Canadian Bankers Draw Scrutiny on How Bond Deals Are Divvied Up

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After more than 30 years in the Canadian investment business, John Poulter has given up on his country’s bond market.

The chief investment officer of Portfolio Strategies Securities Inc., which manages about C$250 million ($205 million) for individuals, says the market is so dominated by institutional investors that he can’t get a fair price when buying newly issued bonds or when trading them afterward. Now, when he wants to put client’s money in fixed-income securities, he does it through exchange-traded funds.

“We’ve given up on it completely and don’t hold individual bonds,” Poulter, 54, said by phone from Toronto. “Trying to deal with individual bonds is a bit of a mugs game.”

Ontario’s securities regulator is taking note. The agency said last week that it’s broadening a review of transparency in Canada’s C$1 trillion corporate bond market to examine whether banks and other investment dealers give smaller investors fair access to new debt sales.

Canadian authorities are following similar moves by regulators in the U.S. and Europe as a continuing rally in fixed income has seen the bond market, still largely conducted in opaque private transactions over the phone, swell to $45 trillion worldwide.

Deal Allocations

“We have had some general concerns raised with us regarding fairness in allocations by dealers to clients,” said Susan Greenglass, the Ontario Securities Commission’s director of market regulation, in an e-mailed statement. “In particular, the limited availability of smaller market participants to participate in debt offerings.”

The OSC says it is investigating how investment dealers allocate new issues to determine if new regulation is needed. At the same time, the regulator says it is continuing with efforts to improve transparency in the market. It’s made getting more information, such as the price a security last traded at, in the hands of smaller investors a priority.

The OSC will publish a regulatory plan for the bond market in the summer, Greenglass said.

Unlike stocks, bonds aren’t traded on public exchanges, but as private transactions with securities dealers acting as middlemen. While Canadian regulators appointed a dealer owned service to disseminate security prices through the market in 2003, it currently covers about half of Canadian corporate bonds, while a U.S. service started around the same time covers the whole market.

Biggest Banks

After criticizing the state of transparency in Canadian trading and launching the review last year, regulators are now turning to new bond sales as well.

For a new issue, investors submit bids and the securities dealers who are underwriting the transaction decide how much each investor gets. In Canada, the nation’s six largest banks are also its largest bond underwriters, according to OSC data.

Last year, Bloomberg News reported the U.S. Securities and Exchange Commission was investigating the way the biggest banks allocate corporate-bond offerings and whether they are giving preferential treatment to certain clients.

“It’s an illiquid market, and so the big players tend to get first choice on larger blocks,” said Poulter of Portfolio Strategies Securities.

The OSC estimates about half of Canada’s C$2.1 trillion bond market is government debt with the balance made up of domestic and foreign corporations, and securitized bonds. Last year Canada saw C$255 billion of new bonds hit the market and C$10 trillion worth of trading, the OSC estimates.

Assumed Risk

Michael Gotzamanis, a spokesman for the Investment Industry Association of Canada, which represents securities firms, declined to comment on the OSC’s scrutiny of new bond issues.

“For a dealer to build a book and figure out what pricing is, they generally have to go to the largest clients out there,” who can commit to large portions of bonds at a certain price to ensure the deal gets done, said Derek Brown, a senior portfolio manager who manages C$6 billion in fixed income at Fiera Capital Corp. in Toronto. “There’s a lot more risk assumed, and price discovery done, by the larger investors.”

Being part of new deals can be profitable. In the U.S., 87 percent of new bond issues went up, with an average one-day return of 0.5 percent, according to research last year by Peter Tchir, the New York-based head of macro strategy at Brean Capital.

Narrower Spreads

Similar gains also take place in Canada.

When Brookfield Renewable Energy Partners LP came to market last month with C$400 million of 10-year notes, the bonds were priced to yield 235 basis points over government bonds. A narrower spread means the bonds are getting more valuable, and the first time a trade on those securities shows up a week later in data compiled by Bloomberg, the spread had narrowed 12 basis points.

A month earlier, insurer Fairfax Financial Holdings came to market with C$350 million of 10-year notes and a spread of 374 basis points more than government securities. The first trade recorded in data compiled by Bloomberg shows the spread had narrowed to 339 basis points.

A small yield-spread premium serves as an incentive for fund managers to sell older holdings and purchase new issues, Brown said.

Ed Waitzer, chairman of the Ontario Securities Commission from 1993 to 1997 and now a senior partner at Toronto-based law firm Stikeman Elliot LLP, said more investigation is needed to determine if more rules on bond sales are needed.

“If this is just big pension funds taking an allocation and sticking it in their portfolio, the fact they get a preference over smaller ones, that’s just the way markets work,” Waitzer said in a Friday phone interview from Toronto. “If they’re flipping it and making that 0.5 percent on hundreds of millions of dollars, then in effect they’re getting paid by the dealers.”

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