The way of the dodo?

Ian Pollick: Let’s play a game. Let’s say that the CMB program is in fact cancelled. Walk me through what that transition looks like. Is there a situation where, and this is speaking to a variety of clients, I’ve gotten a lot of feedback. Scenario number one, does the sovereign buy back CMBs and switch people into Canada bonds? So it’s obviously been a very, very big week. We had the release of the Canadian budget. Within it, the debt management strategy, and in a year where it was not supposed to provide a lot of fireworks, we did get a lot of fireworks. And so, you know, we cannot have a podcast this week without talking about the CMB market. And to that end, I’m joined by Gianluca Gargano. You know him affectionately as Gigi. He runs our government credit franchise. Gigi, welcome to the show, dude.

Gianluca Gargano: Thanks very much, Ian.

Ian Pollick: All right, let’s kick this off. I want to start the conversation, obviously, with the big elephant in the room, and that is the discussion around potentially cancelling the CMB program. Now, as of right now, it is only a consultation, but we’ve seen how these things go. And so we’re not going to speculate. We’re just going to use some facts. But to frame the debate, number one is what happened?

Gianluca Gargano: Yeah. So basically the budget concluded or provided the market with information that the consultation would be conducted on the current CMB program and what methods could be used to basically consolidate it into the Government of Canada program, which would put effectively an end on a 20 plus year program that helped to finance CMHC mortgages within our government credit market.

Ian Pollick: Okay. And so just for context, there’s about 200 billion CMBs outstanding. This is a very large part of the Canadian fixed income market. What was the justification around this?

Gianluca Gargano: I mean, generally, I think politically it was a move to, A, realize savings that were given away with the CMB program and, number two, to use those savings and reinvest them into a social housing strategy which has been core to CMHC’s mandate for the last, I would say 5 to 5 plus years and certainly tried to drive that mandate and improve it.

Ian Pollick: Okay. So look, this is obviously a very big deal, right? And, you know, the problem is we’re operating with very little facts. So let’s just walk through this. You know, I think first and foremost, anyone that’s traded Canada, you’ve traded a CMB. You know, the liquidity profile is spectacular. And so, you know, part of that spectacular liquidity is because you’ve had sponsorship and the sponsorship is a function of visibility, and visibility comes from consistency. And the consistency has been, you know, quarterly auctions. We know exactly what the size is per year. We have a very good framework for it. I have to ask the question, you know, day one, it happened. Scarcity was obviously the most important factor driving spreads, driving valuations. The secondary was liquidity. And so what we saw with, for example, the RB program. You know, a couple of days of scarcity that drove spreads, then liquidity concerns blew them out. As you stand right now, where are you on the scarcity versus liquidity debate?

Gianluca Gargano: I mean, I think we can’t ignore the fact that outstanding is 260 billion of these bonds spread across the entire curve. So certainly there is a significant amount of bonds out there and we will still have likely at least six supply windows this year to conclude the 40 billion program with net issuance still slightly elevated to that amount. So we’ll end up slightly above that 260 billion. The scarcity of these assets I think will be more of a longer term phenomenon. In the current state, there certainly will be liquidity, there will be visibility in these bonds. But as bonds roll off the curve, as the stock of these bonds available to trade in secondary starts to dwindle, which I don’t anticipate it happening within the next year or two. We’re looking three, four years forward where there’s significant roll offs of the CMB curve. That’s where the scarcity argument starts to hold a little bit more water. I think generally the way that I tend to think of this product, we know that it’s a Government of Canada guarantee. We know that part of the spread implied on this CMB program is a function of liquidity premium and the way that this market has evolved over the years. However, when the cessation of this program comes potentially at some point in the near future, the market will need to come to some realization of what’s more important or what’s the more dominating factor liquidity or scarcity, and that will really inform where these bonds or this stock of bonds will trade within the marketplace. Will it be at the original spreads pre-budget announcement, or will we sit at some magnitude of a percentage of that spread relative to Government of Canada’s? And my personal opinion is that liquidity premiums have varied from time to time. We obviously go through different points in the market where liquidity becomes much more constrained and becomes much more important to investors. But typically liquidity premiums have ranged 10 to 25 basis points. So my argument would be that these should settle somewhere around half of the spread that they currently sit at. And I think they’re allowed to do that because one of the things that I think we need to acknowledge is CMBs play an important or occupy an important space within the HQLA level one asset universe. And in the absence of a constant stock of 40 billion every single year and a program that maintains benchmark status in fives and tens, that still is an asset that will be very valuable and there isn’t a natural replacement asset to occupy that space that CMBs have taken for so many years.

Ian Pollick: Okay. So if I understand correctly, your forecast or your projection is, where are five year spreads right now?

Gianluca Gargano: Five year spreads are, call them four, four and a half basis points richer from the pre announcement. So saying probably around 29.5 versus five years on June 28th.

Ian Pollick: And so two things on that. Number one is, given what you just said, you think that when all the dust is settling, as you get closer to the permanent cessation announcement, these things kind of settle half that, like 15 basis points.

Gianluca Gargano: They could.

Ian Pollick: Wow. That is that is very optimistic, Gig.

Gianluca Gargano: But I think one of the things that we can’t exclude in this discussion is the fact what is the broader impact that cancelling the CMB program is going to have on the Government of Canada curve?

Ian Pollick: Oh, for sure. And I think one of the things that we saw in the budget was, yes, overall notional issuance, gross issuance is going down, but the composition is skewed and in particular it’s skewed to the belly. And so when I read it and I kind of went through the numbers, you know, net supply in the dv01 terms, notional terms, it’s not great for five years, right? And I think you’ve seen this five year underperformance. And so the question is the way that I interpret it, the CMB trust still exists, but the funding moves from one market to another and that other is the GoC market. And so that puts a lot of pressure on the bond program because I find it hard to believe that if you are funding CMBs and let’s say the cap is maintained at 40 billion, that you’re going to do anything other than fives and tens, you know, why would you use twos or 30s to fund that type of vehicle? And so I think it puts a lot of additional pressure. It raises term premium and it cheapens the belly, you know, And so those macro butterflies, twos fives tens or fives tens 30s all of a sudden start to get this headwind from this additional supply that is irrespective of what the deficit was. And so I guess the question I have for you, too, as well is you gave us a delta and you said what they’re for tighter since budget?

Gianluca Gargano: Roughly.

Ian Pollick: But where are they from the day after? So like I know they move the most day one. Give us context. So in the first day how much did they move?

Gianluca Gargano: I mean, obviously it was pretty challenging to really observe where the market was. However, I would say that they were anywhere from 10 to 12 basis points tighter.

Ian Pollick: So an Infinity Sigma move.

Gianluca Gargano: Yes.

Ian Pollick: Okay. Got it.

Gianluca Gargano: And certainly a significant outperformance to the provincial curve. However, you know, when the market had an opportunity to digest what actually had transpired and people obviously are looking at CMB still in conjunction to other government credit sectors as it is one of the core pillars of valuation within the government credit sector. That valuation started to then skew back towards the left and we’re settling in, in and around these levels and provincials for that matter, have actually caught pace with the move in CMBs now.

Ian Pollick: They’re having that spill-over impact where you get this concern of, well, maybe if I can’t trade these things as liquid as before, I need another asset. And remember, probes are level two assets, correct? Are they level one assets? Okay. They’re level one assets. Okay. I have a question for you. When we think about the index, how do you foresee the cessation impacting the index? Because CMBs now live in the federal index. So it’s just the actual weight may shift if you take 40 billion out of it. But on the other hand, you’re adding 40 billion back onto Canada. So is there really an impact shift?

Gianluca Gargano: It’s one exchanging for the others. So as CMBs roll off and there is no issuance of CMBs, then you will basically replace them with Government of Canada’s.

Ian Pollick: So the running carry of that index will decline.

Gianluca Gargano: Will decline on the assumption that we don’t have a material repricing-. 

Ian Pollick: Of CMBs.

Gianluca Gargano: of the Canada curve.

Ian Pollick: And Canada curve. That’s true.

Gianluca Gargano: Right. So I guess the other argument that I kind of think about is if we’re imposing a 40 billion program on top of the Government of Canada curve that supposedly was 13 billion less in supply from the incoming year, then what impact will that have to yields? But more importantly, what impact will it have to swap spreads? Because that will be the second round catalyst for driving spreads within the government credit sector tighter because the asset swap valuations will cheapen significantly and potentially that drives another round of HQLA buying of level one assets.

Ian Pollick: That’s a good point, right, because one of the things that we’ve seen in Canada is, you know, spreads did what they were supposed to do during quantitative easing, you know, i.e. cash outperformed. But what we didn’t see is when QT started, we didn’t see a big narrowing of spreads because cash did not necessarily underperform. And so everyone’s been waiting for this non kind of mortgage related impact on the spread curve. And this could be it, right? If you’re talking about additional issuance, then belly spreads in particular could be under severe pressure and that could bring a secondary round of buying, you’re saying? That’s an interesting point. And so, you know, I’m going to blow your mind right now because obviously, you know, I’m a worldly guy and I wanted to try and find globally if there’s any other precedents or something like this happening. And I actually did find something, you know, in 2022, the New Zealand Housing Trust or Housing New Zealand bonds actually went through a similar exercise where they were a standalone Crown corporation. They issued bonds in New Zealand. The funds were used for sustainability housing for to build low income rental units and that program actually was reabsorbed by the sovereign bond program last year. And so what I looked at what happened to spreads in Housing New Zealand, again, this is not nearly the size of the CMB program. I think there’s about 10 billion outstanding in New Zealand. So do the multiplier impact to bring it back to CAD. But spreads initially tightened around 20 or 30 basis points across the curve, but since then they’ve rewidened out. And so relative to that cessation announcement, these spreads are probably 30 basis points wider. And so when we’re thinking about are there precedents of liquidity versus scarcity, this one is clearly one of scarcity lost out. Now, those bonds had a 20% risk rating, right? And so I think one of the things people were expecting is they would become basically flat to New Zealand bonds in HQLA treatment, which they were not. And this is very different than what CMBs are.

Gianluca Gargano: Absolutely different. CMBs, nothing will change on the actual collateral. By definition, HQLA level one assets carry the full sovereign guarantee and the CMB bonds nothing is changing on that guarantee. So that’s one important distinction that I think could potentially result in a different spread reaction over time of the CMB program. But ultimately, I think the argument always comes back to what market are we in and what is more valued? Is it scarcity or is it the liquidity premium? And what we know, at least over the last six months, liquidity has been an absolute primary factor that has driven investors and we have seen flows that have completely spoken to that where all investors were trying to get more liquid into benchmark areas of the curve and the most liquid areas of the government credit sector.

Ian Pollick: So remind me, the next round of supply is what, in May?

Gianluca Gargano: Mid May.

Ian Pollick: Okay. And so, you know, gun to your head, what are you thinking?

Gianluca Gargano: Yeah, I think, you know, this is one of the other challenges. So given how little we know about this consultation and how it will actually end up being implemented, I think there will be increased levels of volatility around supply. Clearing levels will be somewhat challenged. I mean, obviously, I think the market will find its momentum and equilibrium over the next several weeks and hopefully there’s some better sense of calm and the valuations people become comfortable between provincial CMBs and potentially the federal asset manager space. But certainly there will be increased scrutiny on those deals where there will be different drivers for these upcoming deals. For example, those looking for HQLA assets will have certain targets that they will want the CMBs to trade at in order for them to be able to participate in a meaningful way. And in the absence of that, then you will have to look at some of the other drivers of value that have been key success factors for supply, and that involves obviously the international community and others within the domestic community that participate in this type of product.

Ian Pollick: So for sure. So is that a way to say that relative to historical issuance trends, that we could see more of a concession built around this upcoming round of supply?

Gianluca Gargano: There could. There could potentially for sure. And you know, I would say this in my entire career dealing with this program, the issuer has been very sensitive to investor feedback in terms of pricing deals properly in the market, allowing them to clear in a suitable fashion and leaving room for performance. So I don’t negate that that will be something that will be on the table and the issuers will look at very closely as they are coming to market and taking the advice from their lead syndicate.

Ian Pollick: Okay, that’s a great point. And so let’s play a game. I like games. You like games?

Gianluca Gargano: Sure.

Ian Pollick: Let’s play a game. Let’s say that the CMB program is in fact, cancelled. Walk me through what that transition looks like. Is there a situation where, and this is speaking to a variety of clients. I’ve gotten a lot of feedback. Scenario number one, does the sovereign buy back CMBs and switch people into Canada bonds? Is that realistic in your mind?

Gianluca Gargano: It doesn’t in the spirit of what they’ve actually set out to do in the budget. The purpose of this collapsing of the program into the Government of Canada program is to realize savings. With most of these bonds still trading at a significant spread to Canada’s, they would effectively need to tender these bonds much closer to the Canada level, so flat to Canada’s. So I fail to see how buying those bonds, even if they were just buying very short duration bonds, is going to achieve that objective of taking these bonds out of the market and paying out premiums because it will eat away at any of the initial outyear savings for the 40 billion program.

Ian Pollick: Well, I mean. Look, tuition costs money, right? And so do you need to write a check to people to get this thing done is the question.

Gianluca Gargano: Because there will be value, right? And obviously, we know that in buybacks historically, when we look at the cessation of other agency programs like Farm Credit, BDN, FBDN, a lot of the behaviour of those bonds was initially to tighten, then widen out. And then on the back of an announcement of a buyback, they traded very, very snug to the Government of Canada curve.

Ian Pollick: Okay. So you do expect convergence. That is your base case.

Gianluca Gargano: There could be, I don’t think, a buyback would be on the table initially because I think there’s so many other things to work out in terms of the logistics. Obviously, the structure in CMB is much different than what we have in terms of a structure with those other Crown corporations that we talked about. The presence of a trust and all of the administration around it and how the hedging specifically works requires some additional intricacies that wouldn’t have been present with those other programs.

Ian Pollick: Well, there’s a lot more mechanics that are involved that people do not see in the CMB program. The way that these bonds are allowed to be bullets requires a tremendous amount of swaps in the background. There’s a lot of market participants, right? So one of the things we haven’t talked about and you kind of briefly mentioned it was federally regulated asset managers. And so that seems to be a part of the market that’s going to get a big lift from potential cancellation of the program. Just walk me through your thoughts.

Gianluca Gargano: Yeah, certainly. So. I mean, I think the whole argument is the HQLA level one universe is contracting. We know that. With declining stock of NHANBS with potentially in the future, CMBs not being a part of that universe, it leaves a significant gap in that universe that was occupied by those two issuers. So specifically investors that we’ve spoken to over the last couple of days in a variety of different capacities are all concerned with where the replacement assets will be. What assets within the government credit space have similar profile, have similar levels of liquidity, will have similar constant access to capital markets with commitment to benchmark issuance.

Ian Pollick: Consistency, right?

Gianluca Gargano: Consistency. And we know that the federal asset manager space is one of the growing spaces in terms of issuance and will also be one of the more constant fixtures within the domestic space, not only the international space, which primarily was their key source of funding in the case of, for example, CPP.

Ian Pollick: Okay. That’s really interesting. And so, you know, what I also want to talk about is Provincials, right? So we’ve gone through obviously a period where we’ve got all the budgets, we’re all down. And so I just did a little tabulation. So last year, at least from what we get from the public data, what we see is that there was about 77 billion of issuance. Given all the boring programs that were stated over the past two months, that tally right now is about 99 billion. And so that by itself is about a 28% increase. However, there’s fiscal deterioration and what was very common in all these budgets was there was a forecasted headline deficit as a baseline, but then a risk scenario where if the economy got worse, fiscal headwinds got created, there’d be more issuance. And so our official estimate is that there’ll be an additional 10 billion. So 110 billion is our number. That is over 40% year on year increase. Are you saying or do you think that this CMB discussion is enough to protect spreads from that additional supply? Because 40% is a massive number.

Gianluca Gargano: It depends because you have to consider a couple of different things. How will those issuers come to market? Will they use international markets more than they have in the past year?

Ian Pollick: Well, we know Ontario’s not, right? It’s always all domestic.

Gianluca Gargano: So the names that we’re looking at is B.C., Quebec, Manitoba and potentially Alberta as candidates for the international market. But we know as well that they are also very sensitive to where funding arbitrages are. And if liquidity, like we’ve been talking a lot about today, is a major concern, those markets typically are not where they need to go. So to me, this whole scenario of cessation of CMBs, a potentially growing provincial borrowing backdrop, all leads to steeper credit curves and certainly a repricing within the domestic space where we know provincials like to live, which is in the ten and 30 year area of the curve. Now, the one counter to that is the absence and contraction of the HQLA universe creates an additional lever that will allow some of these provinces, if tens and longs are not possible-

Ian Pollick: To move further up the curve?

Gianluca Gargano: To move further up the curve, fives and sevens, which we have seen. We have seen it in a variety of different scenarios earlier in this last sort of fiscal year for the provinces and certainly in 2020 when markets weren’t operating efficiently and tens and longs couldn’t get done.

Ian Pollick: Well, it’s interesting, right, because all of a sudden you have a very crowded footprint because what we know from the DMS or the debt management strategy, you know, 30 year supply is dropping a lot year on year. Now if you get this move because you have a hole in the market where they start to issue more fives and sevens to our earlier point, it just further exaggerates that cheapness in the belly of the Canada curve as well. And so you do have a lot of participants in a very small part of the curve that it could get very messy, I think. Okay, look, we’ve talked for 20 minutes. That’s a lot for this podcast. And so final thoughts? You okay? (laughs)

Gianluca Gargano: Yeah. Yeah. I mean, I think the market will find its equilibrium. I think in these markets, you know what works really well and we’ve been through several cycles of this in iterations is, you know, really staying connected with the clients, reaching out, sharing valuable information and views on how we believe things will evolve. And really, that’s the way the market finds its way.

Ian Pollick: Okay, so you heard it here first, Gigi has the Jurassic Park view of the world. Life always finds a way. Listen, thank you very much for listening. We hope you all have a great weekend. And remember, with the exception of CMBs, there are no bonds harmed in the making of this podcast.

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