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Foreign Investment in Canadian Bonds.


With an eye on Canadian personal debt levels, Bank of Canada Governor Mark Carney has been delivering a consistent and persistent message: interest rates will go up. Meanwhile, Federal Finance Minister Jim Flaherty has taken steps to tighten up credit availability to already highly indebted borrowers.

Like good portfolio managers, Governor Carney and Minister Flaherty are preparing the marketplace for eventually higher interest rates. They are managing the controllable. What is not being said is the uncontrollable outlier risk of an interest rate shock from foreign investors in Canadian bonds.

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The message from both Bank of Canada Governor Mark Carney and Finance Minister Jim Flaherty is clear. Canadian debt levels are too high and, before interest rates move higher, Canadian’s would be well advised to get their financial houses in order. Governor Carney reminds us with every speech or interview that low interest rates will end. Meanwhile Minister Flaherty has increased mortgage lending standards and requirements through CMHC.

The statistic / chart most often referred to is Canadian debt to income.

Canadian household debt to income

Chart source: Economist.com

Carney and Flaherty recognize that, while Canadian indebtedness is uncomfortably high, today it’s manageable. And it’s prudent to encourage measured and gradual improvements to Canada’s mortgage portfolio while debt levels are still manageable. When interest rates do increase, debt levels will be less serviceable for the marginal borrower (especially in the over-priced and over-leveraged residential mortgage market place).

(One would think that, on the basis of debt to income alone, individuals would have long ago been prudently reducing debt and hesitating before buying more real estate at ever higher prices. But, no, cheap debt encourages endless borrowing with little regard to eventual capacity to pay).

What’s not being said?

Prudent, measured and gradual sound like things are under control. What is not controllable is an outlier interest rate shock that could be caused by foreign investors in Canadian bonds.

Foreign investment in Canadian bonds has increased by 60% to over $620 Billion in the four years since the end of 2007. (Total value of the Canadian bond market is ~$1.1 Trillion).

Foreign investment in Canadian bonds

Chart data source: Statistics Canada

Another market disaster or financial fiasco might cause investors to (again, as always) rush to the safe haven of U.S. Bonds. (U.S.investors own $372 or 60% of the above $620 Billion. In a rush to a safe haven, there’s no place like home).

Europe could again blow up or investors could again feel comfortable enough to invest in Euro bonds. Either way, investors might swap Canada bonds for Euro bonds.

Emerging markets could slow enough to moderate commodities demand and cause commodities countries, like Canada, to be relatively less attractive as investments.

Under any of these scenarios, a quick exit (of the practically overnight kind) from Canada bonds means a lot of sellers all in a hurry. Investors know that when there are more sellers than buyers, prices drop. And when bond prices drop, bond yields increase.

So what?

Mortgage rates are priced off bond yields. Higher mortgage rates would flatten demand for mortgages and houses meaning house prices would drop (or, at least, stop increasing). Costlier borrowing and/or house price declines mean real estate investment properties would become less attractive and the supply of homes for sale would increase depressing prices further still.

For those already at capacity debt to income, having to renew a mortgage at higher rates than the 2.99% mortgage just barely qualified for means you’re going to have a bad day. Just ask your American cousins.

And Governor Carney won’t be able to help save the day by dropping interest rates because they are already near zero. Sound dramatic? Not for the over-extended. No wonder, Carney and Flaherty are tightening the screws.

Now is a good time to pay down debt and hold short bonds and cash.

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Next time? More Risk Management.
Doug Cronk, CFA is Manager, Investments for a Canadian Pension Plan
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