In November 2005, officials from the Department of Finance and the Bank of Canada sought views from Government Securities Distributors and institutional investors on a number of issues related to the design and operation of domestic debt programs. The consultations served as input to the development of the 2006/07 debt strategy and were in keeping with the government's ongoing commitment to consult with market participants. The debt strategy consultations identified a broad spectrum of potential adjustments to the government's bond program in the near and medium terms to maintain a well-functioning market for Government of Canada securities in light of lower borrowing requirements and evolving market trends. This document provides a summary of the views received during these consultations.
In Brief
Market participants recognized that the government faces challenges in maintaining well-functioning markets for Government of Canada bonds in a context of lower borrowing needs and movement towards a lower fixed-rate share of the government debt. Views from market participants varied with respect to the adjustments that should be made to reduce the bond program over time. In general, market participants stressed the importance of maintaining large liquid benchmark bonds in all four maturities and the current issuance cycles, but suggested that there may be some scope for modest reductions in the issuance and size of benchmark bonds. They strongly supported continuing to take advantage of fungibility in the 2-year sector and changing the 5-year maturity date from 1 September to 1 June to support issuance in other sectors. To support the buyback program and to maintain large liquid benchmark bonds in all four maturities, market participants indicated that a modest reduction in the $6 billion bond buyback floor, below which benchmark bonds are currently not repurchased, is acceptable. In the context of lower borrowing requirements, a number of market participants suggested consolidating the borrowings of Crown corporations to support the liquidity of the Government of Canada bond market and therefore minimize the cost of funding for the government and for the Crowns.
Market liquidity
Most participants are of the view that liquidity is adequate along the yield curve yet limited at times for long-term bonds. Market participants indicated that there is strong demand for Government of Canada securities and noted the decreasing supply, especially the supply of long-term products where there is a structural need for bonds and limited substitutes. They commented that pressures on market liquidity will intensify because the number of buy-and-hold investors and the demand for collateral are increasing. However, market participants indicated that a further small decrease in the size of the bond program should not cause a dramatic change in liquidity. In recent years market liquidity has benefited from the increase in the trading of 10-year CGB futures contracts and the growth of hedge funds.
Potential measures over the near term
Views from market participants varied with respect to the adjustments that should be made to reduce the size of the bond program over the near term. They commented that taking advantage of fungibility between Government of Canada securities has been very effective in supporting the liquidity of building benchmark bonds and should be continued. Some participants recommended that all bonds become fungible over time. But some participants cautioned that the fungibility process is most effective when stripping higher-coupon bonds and reconstituting them into lower-coupon bonds in an ongoing positive yield curve environment.
Foregoing fungible 2-year issuance
Market participants indicated that foregoing one 2-year fungible auction on a permanent yearly basis is feasible and that it may encourage increased trading in the 2-year and 5-year futures contracts over time. Views were mixed in regard to the appropriate balance between fungible and non-fungible bonds.
Changing the maturity cycle of 5-year issuance
Changing the maturity of the 5-year benchmark bond from September to June received the strongest support among the initiatives presented during this year's consultations. Market participants indicated that using fungibility in the 5-year sector to reduce issuance would be more effective than in the 2-year sector, partly because there are more alternative bond investments in the 5-year sector. They did not identify any issue arising from this measure that would negatively affect trading in corporate, futures and swap markets. A small number of participants indicated that concentrating all bond maturities in June could give them challenges in cash management and index-extension trading, but most were confident that the market would adapt and that any potential challenges would be more than offset by increased liquidity resulting from this measure. Others highlighted that this adjustment would take place over time and that the impact would be gradual. With regard to increasing the amount of outstanding debt on a particular maturity date, a large majority of participants believed that there is considerable room before a Government of Canada benchmark bond would become so large that it could negatively affect the government's funding cost or the functioning of the market.
The bond buyback program
The bond buyback program continues to receive strong support from market participants for its important role in maintaining the gross issuance of Government of Canada bonds. Participants acknowledged that aside from a few small adjustments to help improve the operation of the program, the role of the buyback program should decline with time and that the government should be envisioning other options to support a smaller bond program.
To support the buyback program and maintain large liquid benchmark bonds in all four maturities, market participants indicated that a $1 billion reduction in the $6 billion buyback floor (below which the older benchmark bonds are currently not repurchased) would be acceptable. The views of some participants differed depending on the maturity sector in question. In addition, broadening the basket of eligible bonds to include off-the-run issues (one time, old benchmark bonds) received less overall support.
Use of interest rate swaps
The concept of using an interest rate swap (IRS) program as a tool to maintain gross issuance and benchmark sizes was discussed with dealers and investors. Overall, market participants were generally supportive. They indicated that the market could absorb an increase in interest rate swaps. A wide variety of views were expressed as to the operational aspects of a swap program, such as its potential size, the proper transparency required in conducting operations, and its impact on the market.
Those supporting IRS are of the view that a program could attain at least the size of the cross currency swap program (about $5 to $7 billion). Market participants indicated that the liquidity of the swap market has increased in recent years and believed that the government could establish an IRS program with transparency achieved by a timely disclosure of program size. Some participants indicated that provinces and hedge funds could be counterparties counterbalancing the government's flows in the market.
Those expressing concerns about the operational aspects of an IRS program indicated that it may create increased volatility in the market and contribute further to liquidity issues in the repo market because of the hedging activity of swaps using benchmark bonds.
Potential measures over the medium term
Views from market participants varied with respect to the adjustments that should be made to reduce the size of the bond issuance program over the medium term if financial requirements continue to decline.
Reducing the sizes of current benchmark targets
In general, participants agreed that there may be some scope for modest reductions in the size of auctions and benchmark issues, but stressed the importance of maintaining large liquid benchmark bonds in all four maturities and the current issuance cycles.
Changing issuance pattern of some regular auctions
Market participants' views were mixed regarding the trade-off between the size and frequency of auctions. Those in favour of more frequent smaller auctions commented that they would reduce the government's funding cost, disrupt the market the least, and help facilitate cash-flow management. Those against indicated that larger auctions provide liquidity, may prevent market manipulation (which could be associated with smaller auctions), increase visibility of the Canadian market internationally, and tend to be more useful for dealers. They indicated that the market might be reluctant to build a book before the auction if it is too small, which may affect the success of the auction. Participants on both sides expressed concerns regarding the increased chance of a "squeeze" with smaller auctions, especially after the first auction of a new benchmark bond.
Most market participants agreed that issuing 30-year bonds exclusively through switch operations should be considered only as a last step before eliminating a maturity sector. They indicated that the problem with this measure is that there is a strong demand for long-dated issues, and participants may not have the required bonds to exchange.
Eliminating a maturity sector
Market participants did not support eliminating the issuance in any of the four key maturity sectors. Most recommended modestly reducing issuance in all maturities as opposed to eliminating one particular sector. If a maturity needed to be eliminated, however, participants indicated that removing one of the two 2-year benchmark bonds should be considered first and removing the 5-year sector should be considered second, since alternative investments exist in both sectors. No participant suggested eliminating the issuance of 10-year bonds, and participants expressed considerable resistance to eliminating the 30-year nominal and/or real return bonds. A number of market participants mentioned that they would prefer consolidation of Crown borrowings into the government's borrowing program to maintain the liquidity of the market, instead of the elimination of one maturity. They noted that this would also reduce costs for the government and for the Crowns.
Adjustment to the auction calendar
Most participants did not foresee any significant issue with changing the sequence of auctions aimed at improving the government's cash management. However, market participants recommended maintaining the timing of auctions of real return bonds, which closely follow the bond's coupon payment dates.