BMO Harris Opportunity Bond Portfolio et al. - MRRS Decision
Headnote
Mutual Reliance Review System for Exemptive Relief Applications -- s. 19.1 of National Instrument 81-102 Mutual Funds -- exemption from section 2.7 (1)(a) of NI 81-102 insofar as it requires an interest rate swap to have a remaining term to maturity of 3 years (or 5 years in certain circumstances) to permit the Funds to enter into an interest rate swap with a remaining term to maturity of greater than 3 years; exemption from section 2.8(1) of NI 81-102 to the extent that cash cover is required in respect of specified derivatives to permit the Funds to cover specified derivative positions with: i) any bonds, debentures, notes or other evidences of indebtedness that are liquid with a remaining term of 365 days or less or ii) floating rate evidences of indebtedness; and exemption from sections 2.8(1)(d) and (f)(i) NI 81-102 to permit the Funds when they open or maintain a long position in a standardized future or forward contract or when they enter into or maintain an interest rate swap position and during the periods when the Funds are entitled to receive payments under the swap, to use as cover, an option to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap -- the relief will increase the possibility of enhancing returns to investors while still providing adequate safeguards.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.7(1)(a), 2.8(1), 2.8(1)(d), 2.8(1)(f)(i), 19.1
February 1, 2006
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
BRITISH COLUMBIA, ALBERTA, SASKATCHEWAN,
MANITOBA, ONTARIO, QUEBEC, NEW BRUNSWICK,
NOVA SCOTIA, PRINCE EDWARD ISLAND,
NEWFOUNDLAND AND LABRADOR
(THE JURISDICTIONS)
AND
IN THE MATTER OF
THE MUTUAL RELIANCE REVIEW SYSTEM
FOR EXEMPTIVE RELIEF APPLICATIONS
AND
IN THE MATTER OF
BMO HARRIS OPPORTUNITY BOND PORTFOLIO,
BMO HARRIS INCOME OPPORTUNITY BOND
PORTFOLIO AND BMO HARRIS INVESTMENT
MANAGEMENT INC. (COLLECTIVELY, THE FILERS)
MRRS DECISION DOCUMENT
Background
The local securities regulatory authority or regulator (the Decision Maker) in each of the Jurisdictions has received an application from the Filers for a decision under the securities legislation of the Jurisdictions (the Legislation) exempting BMO Harris Opportunity Bond Portfolio and BMO Harris Income Opportunity Bond Portfolio (collectively, the Funds) pursuant to Section 19.1 of National Instrument 81-102 Mutual Funds (NI 81-102) from the requirement in:
1. section 2.7 (1)(a) of NI 81-102 insofar as it requires an interest rate swap to have a remaining term to maturity of 3 years (or 5 years in certain circumstances) to permit the Funds to enter into an interest rate swap with a remaining term to maturity of greater than 3 years;
2. section 2.8(1) of NI 81-102 to the extent that cash cover is required in respect of specified derivatives to permit the Funds to cover specified derivative positions with:
a) any bonds, debentures, notes or other evidences of indebtedness that are liquid (Fixed Income Securities);
b) floating rate evidences of indebtedness; and
3. sections 2.8(1)(d) and (f)(i) NI 81-102 to permit the Funds when:
a) they open or maintain a long position in a debt-like security that has a component that is a long position in a forward contract or in a standardized future or forward contract; or
b) they enter into or maintain an interest rate swap position and during the periods when the Funds are entitled to receive payments under the swap;
to use as cover, a right or obligation to sell an equivalent quantity of the underlying interest of the standardized future, forward or swap.
(paragraphs 1, 2 and 3 collectively will be referred to as the Requested Relief)
Under the Mutual Reliance Review System for Exemptive Relief Applications:
(a) Ontario is the principal regulator for this application, and
(b) this MRRS decision document evidences the decision of each Decision Maker.
Interpretation
Defined terms contained in National Instrument 14-101 Definitions have the same meaning in this decision unless they are defined in this decision.
Representations
This decision is based on the following facts represented by the Filers:
The Funds
1. The Funds will be mutual fund trusts established in Ontario for which BMO Harris Investment Management Inc. (the Manager) will be the manager and the investment manager and Pacific Investment Management Company LLC (PIMCO) is the sub-adviser. The Funds will be offered by prospectus in all the Jurisdictions. The Funds have filed a preliminary prospectus dated December 16, 2005 in the Jurisdictions under Sedar Project No. 870918. The Manager's head office is in Toronto, Ontario.
2. The investment objectives of the Funds are to invest primarily in a diversified pool of fixed income securities, such as bonds and debentures issued by governments and corporations or gain exposure to such securities. The Funds may also invest in inflation protected securities, securities backed by mortgages or other financial assets and instruments that provided exposure to these fixed income securities.
3. The Funds may use derivative instruments to gain exposure to securities and markets instead of investing in the securities directly. The Funds may also use derivative instruments to reduce risk by protecting the Funds against potential losses from changes in interest rates and reducing the impact of currency fluctuations on the Funds' portfolio holdings.
PIMCO
4. PIMCO is one of the world's largest fixed income managers. PIMCO is an adviser, registered under the Investment Advisers Act in the US. Organized in 1971, PIMCO provides investment management and advisory services to private accounts of institutional and individual clients and to mutual funds around the world.
5. PIMCO has discussed with BMO Harris Investment Management Inc. the investment guidelines for the Funds and as a result PIMCO will be able to use tools consistent with NI 81-102 and this exemption in managing the Funds.
6. Strategies employed by PIMCO in managing fixed income portfolios in the United States (U.S.) including U.S. mutual funds, in European jurisdictions complying with UCITS and other regulators, are currently prohibited by NI 81-102.
Swaps
7. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into certain over-the-counter derivatives transactions, including interest rate swaps, with terms to maturity of greater than three years, or greater than five years if the contract provides the fund with a right to eliminate its exposure within three years. The Filers seek the ability to enter into swaps on behalf of the Funds without a restriction as to term of the swap. The Filers believe that the limit of 3 years for interest rate swaps may have to do with regulatory concerns regarding liquidity risk and credit risk which are addressed below.
8. The term of a swap equals the maturity of its exposure, in contrast to other over-the-counter transactions, such as options and forwards, where the contract term and maturity of the underlying security are not related. As a result, there is no restriction under NI 81-102, for example, on a forward with an underlying interest having a term of 10 years whereas there is a restriction if the derivative is in the form of a swap.
9. The interest rate swap market is the largest interest rate market in the world, and one of the most liquid. Swap markets are generally as liquid as government bonds and more liquid than corporate bonds. The Bank of International Settlements reports $127 trillion in interest rate swaps outstanding as of June 30, 2004. In Canada, there are over $1 trillion of interest rate swaps outstanding, more than double the federal and provincial debt.
10. Because swap contracts are private agreements between two counterparties, a secondary market for the agreements would be a cumbersome process whereby one counterparty would have to find a new counterparty willing to take over its contract at a fair market price, get the original counterparty to approve the new counterparty, and exchange a whole new set of documents. To avoid that process, market participants unwind their positions by simply entering into an opposing swap with an acceptable counterparty at market value. In this way, the original market or interest rate risk is negated.
11. Credit risk exposure to a counterparty on a swap transaction is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap. Even that small risk will be mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102.
12. By permitting the Funds to enter into swaps beyond 3 year terms, it increases the possibility for the Funds to increase returns due to the fact that the opportunity set of swaps is expanded and it enables the Funds to target exposure that might not otherwise be available in the cash bond markets. Further, it enables the Funds to effect hedging transactions that are more efficient and tailored.
Using Fixed Incomes Securities and Floating Rate Debt as Cover
13. Section 2.8 of NI 81-102 requires that mutual funds cover their derivative positions with "cash cover".
14. The current definition of "cash cover" in NI 81-102 includes:
(a) commercial paper that has a term to maturity of 365 days or less and an approved credit rating and that was issued by a person or company other than a government or permitted supranational agency; and
(b) cash equivalent that is an evidence of indebtedness with a remaining term to maturity of 365 days or less, and that is issued, or fully and unconditionally guaranteed as to principal and interest, by government entities that are listed in the definition of "cash equivalent" as defined in NI 81-102.
15. The purpose of the cash cover requirement in NI 81-102 is to limit a mutual fund from leveraging its assets when using certain specified derivatives under section 2.8 and to ensure that the mutual fund is in a position to meet its obligations on the settlement date.
16. The Filers propose to use liquid Fixed Income Securities and floating rate evidences of indebtedness as cover for specified derivative transactions with respect to the Funds.
17. While money market instruments which are required by NI 81-102 as cash cover are highly liquid, the price paid for that liquidity comes in the form of very low yields relative to longer dated instruments and even relative to similar risk alternatives.
18. The definition of "cash cover" addresses regulatory concerns of interest rate risk and credit risk by limiting the term of the instruments and requiring the instruments to have an approved credit rating. The Filers submit that by permitting the use of Fixed Income Securities with a remaining term to maturity of 365 days or less and an approved credit rating as cover for specified derivative transactions with respect to the Funds, the regulatory concerns are met since the term and credit rating will be the same as other instruments currently permitted as use as "cash cover". Further, the longer dated instruments will enhance yields for the Funds.
19. Floating rate evidences of indebtedness, also known as floating rate notes (FRNs), are debt securities issued by the federal or provincial governments, Crown corporations or other corporations and other entities with floating interest rates that reset periodically, usually every 30 to 90 days. However, the term to maturity of FRNs can be more than 365 days.
20. The Filers propose to meet the cash cover requirement in section 2.8 of NI 81-102 by investing in FRNs that have a remaining term to maturity of more than 365 days and with interest rates that reset no longer than every 185 days.
21. The Filers submit that the use of FRNs as cash cover can enhance the return of the Funds without reducing the quality of "cash cover" for the purposes of specified derivatives.
22. For the purposes of money market funds (as defined in NI 81-102) meeting the 90 days dollar-weighted average term to maturity, the term of a floating rate evidence of indebtedness is the period remaining to the date of the next rate setting.
23. There is considered to be minimal interest rate risk associated with FRNs as floating interest rates generally reset on a short term basis, such as every 30 days to 90 days. Credit risk aside, if a FRN resets every 365 days, then the interest rate risk of the FRN is about the same as a fixed rate instrument with a term to maturity of 365 days.
24. Further, financial instruments that meet the current "cash cover" requirement have low credit risk. The current "cash cover" requirements provide that evidences of indebtedness of issuers, other than government agencies, must have approved credit ratings. As a result, if the issuer of FRNs is an entity other than a government agency, the FRNs will have an approved credit rating as required in NI 81-102.
25. FRNs will have adequate liquidity and will otherwise meet the requirement for derivative transactions carried out in accordance with Section 2.8.
Using Put Options as Cover for Long Positions in Futures, Forwards and Swaps
26. Sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 do not permit covering the position in long positions in futures and forwards and long positions in swaps for a period when a Fund is entitled to receive payments under the swap, in whole or in part with a right or obligation to sell an equivalent quantity of the underlying interest of the future, forward or swap. In other words, those sections of NI 81-102 do not permit the use of put options or short future positions to cover long future, forward or swap positions.
27. Regulatory regimes in other countries recognize the hedging properties of options for all categories of derivatives, including long positions evidenced by standardized futures or forwards or in respect of swaps where a fund is entitled to receive payments from the counterparty, provided they are covered by an amount equal to the difference between the market price of a holding and the strike price of the option that was bought or sold to hedge it. NI 81-102 effectively imposes the requirement to overcollateralize, since the maximum liability to the fund under the scenario described is equal to the difference between the market value of the long and the exercise price of the option. Overcollateralization imposes a cost on a fund.
28. Section 2.8(1)(c) of NI 81-102 permits a mutual fund to write a put option and cover it with buying a put option on an equivalent quantity of the underlying interest of the written put option. This position has similar risks as a long position in a future, forward or swap and therefore, the Filers submit that the Funds should be permitted to cover a long position in a future, forward or swap with a put option or short future position.
Derivative Policies and Risk Management
29. The Manager allows for the use of derivatives under certain conditions and limitations. The Manager has written guidelines that set out the objectives and goals for derivatives trading which are established and reviewed annually by the board of directors of the Manager.
30. The Manager has written policies and procedures in place on the use of, and to supervise the investment adviser in the use of, derivatives as investments within the Funds. These policies and procedures set out specific procedures for the authorization, documentation, reporting, monitoring and review of derivative strategies and positions. These policies and procedures are reviewed as required, with a minimum annual review.
31. The Manager has a Derivatives Review Committee ("DRC") that reports quarterly, and more frequently if required, to the Board of Directors of the Manager. The DRC is expected to be comprised of the Chief Investment Officer of the Manager, the Chief Compliance Officer of the Manager and other senior members of the Manager research team. Through the DRC, the Manager monitors the trading, holdings and positions of the derivatives portfolio, in conjunction with the investment policies of the Funds, and is responsible for applying and enforcing controls.
32. The derivative contracts entered into by the investment adviser on behalf of the Funds must be in accordance with the investment objectives and strategies of each of the Funds. The investment adviser is also required to adhere to NI 81-102. The Trustee sets and reviews the investment policies of the Funds, which also allows the trading in derivatives.
33. The Manager requires that the investment adviser use risk management processes to monitor and measure the risks of all portfolio holdings, including the derivatives positions in the Funds. The investment adviser will use risk measurement procedures or simulations to test the derivatives holdings of the Funds under stress.
34. The prospectus and annual information form of the Funds will include disclosure of the nature of the exemptions granted in respect of the Funds.
35. Without these exemptions, the Funds will not have the flexibility to enhance yield and to manage more effectively the exposures under specified derivatives.
Decision
Each of the Decision Makers is satisfied that the test contained in the Legislation that provides the Decision Maker with the jurisdiction to make the Decision has been met.
The decision of the Decision Makers under the Legislation is that the Requested Relief is granted provided that:
(i) the Fixed Income Securities have a remaining term to maturity of 365 days or less and have an "approved credit rating" as defined in NI 81-102;
(ii) the FRNs meet the following requirements:
(a) the floating interest rates of the FRNs reset no later than every 185 days;
(b) the FRNs are floating rate evidences of indebtedness with the principal amounts of the obligations that will continue to have a market value of approximately par at the time of each change in the rate to be paid to the holders of the evidences of indebtedness;
(c) if the FRNs are issued by a person or company other than a government or "permitted supranational agency" as defined in NI 81-102, the FRNs must have an "approved credit rating" as defined in NI 81-102;
(d) if the FRNs are issued by a government or permitted supranational agency, the FRNs have their principal and interest fully and unconditionally guaranteed by
(I) the government of Canada or the government of a jurisdiction in Canada; or
(II) the government of the United States of America, the government of one of the states of the United States of America, the government of another sovereign state or a "permitted supranational agency" as defined in NI 81-102, if, in each case, the FRN has an "approved credit rating" as defined in NI 81-102; and
(e) the FRNs meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;
(iii) a Fund shall not open or maintain a long position in a debt-like security that has a component that is a long position in a forward contract, or in a standardized future or forward contract unless a Fund holds
a) cash cover in an amount that, together with margin on account for the specified derivative and the market value of the specified derivative, is not less than, on a daily mark-to-market basis, the underlying market exposure of the specified derivative;
b) a right or obligation to sell an equivalent quantity of the underlying interest of the future or forward contract, and cash cover that together with margin on account for the position, is not less than the amount, if any, by which the strike price of the future or forward contract exceeds the strike price of the right or obligation to sell the underlying interest;
c) a combination of the positions referred to in subparagraphs a) and b) that is sufficient, without recourse to other assets of the Fund, to enable the Fund to acquire the underlying interest of the future or forward contract.
(iv) a Fund shall not enter into or maintain an interest rate swap position unless for periods when the Fund would be entitled to receive fixed payments under the swap, the Fund holds
a) cash cover in an amount that, together with margin on account for the swap and the market value of the swap, is not less than, on a daily mark-to-market basis, the underlying market exposure of the swap;
b) a right or obligation to enter into an offsetting interest rate swap on an equivalent quantity and with an equivalent term and cash cover that together with margin on account for the position is not less than the aggregate amount, if any, of the obligations of the Fund under the interest rate swap less the obligations of the Fund under such offsetting interest rate swap.
c) a combination of the positions referred to in clauses a) and b) that is sufficient, without recourse to other assets of the Fund, to enable the Fund to satisfy its obligations under the interest rate swap.
(v) the Funds shall disclose the nature and terms of this relief in the Funds' prospectus under the Investment Strategies section and in the Funds' annual information form.