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 to permit interest rate and credit derivative swaps 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: any bonds, debentures, notes or other evidences of indebtedness that are liquid; 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.
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) and 19.1.
July 4, 2007
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,
NORTHWEST TERRITORIES, NUNAVUT AND YUKON TERRITORY
IN THE MATTER OF
THE MUTUAL RELIANCE REVIEW SYSTEM FOR
EXEMPTIVE RELIEF APPLICATIONS
IN THE MATTER OF
GUARDIAN GROUP OF FUNDS LTD.
MRRS DECISION DOCUMENT
The local securities regulatory authority or regulator (the Decision Maker) in each of the Jurisdictions has received an application from the Filer for a decision under the securities legislation of the Jurisdictions (the Legislation) exempting GGOF Global Bond Fund (the Bond Fund) and the GGOF Floating Rate Income Fund (the Floating Rate Fund) (collectively, the Funds) pursuant to Section 19.1 of National Instrument 81-102 Mutual Fund (NI 81-102) from the requirements in:
1. section 2.7 (1)(a) of NI 81-102, insofar as it requires an interest rate swap or credit default swap to have a remaining term to maturity of 3 years (or 5 years in certain circumstances), to permit the Funds to enter into interest rate or credit default swaps 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) of NI 81-102 to permit the Bond Fund when:
(a) it opens or maintains 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) it enters into or maintains a swap position and during the periods when the Bond Fund is 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.
Defined terms contained in National Instrument 14-101 Definitions have the same meaning in this decision unless they are defined in this decision.
This decision is based on the following facts represented by the Filer:
1. The Filer is the manager of the Funds. The Filer is registered as an investment counsel/portfolio manager and as a mutual fund dealer. The Manager's head office is in Toronto, Ontario.
2. Each of the Funds is a mutual fund trust established in Ontario. The Funds are offered by prospectus in all the Jurisdictions and are reporting issuers. The Bond Fund and the Floating Rate Fund had net asset values of approximately $24 million and $91 million respectively in May, 2007.
3. The Bond Fund's goal is to preserve investors' capital and provide a competitive total return comprised of capital appreciation and a moderate amount of income by investing primarily in a diversified portfolio of fixed income securities, such as bonds and debentures issued by governments and corporations or by obtaining exposure to such securities.
4. The Bond Fund may use derivative instruments to gain exposure to securities and markets instead of investing in the securities directly. The Bond Fund may also use derivative instruments to reduce risk by protecting the Bond Fund against potential losses from changes in interest rates and reducing the impact of currency fluctuations on the Bond Fund' portfolio holdings.
5. The investment manager of the Bond Fund is Pacific Investment Management Company LLC (PIMCO). PIMCO is one of the world's largest fixed income managers. 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.
6. The Floating Rate Fund's goal is to generate a high level of interest income that will fluctuate in line with short term interest rates with a duration of less than 365 days. The Floating Rate Fund may use financial derivatives to transform the income from high yield bonds and debentures into income equivalent to or greater than that generated by short term floating rate instruments with a term less than 365 days.
7. The investment manager of the Floating Rate Fund is Guardian Capital LP (GCLP). GCLP was formed in 1962 and is one of Canada's longest-established, independent investment counselling firms. Over its 45-year history, GCLP has offered its investment management expertise in balanced fund management, equity management and fixed-income management to pension fund clients, institutions, operating and endowment funds, charitable organizations, mutual funds and high net worth individuals. As of March 31, 2007, GCLP had approximately C$ 16.5 B in assets under management.
8. Section 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into 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 Filer seeks the ability to enter into interest rate swaps and credit default swaps on behalf of the Funds without a restriction as to term of the swap.
9. In order to achieve adequate diversification at a reasonable cost while the Bond Fund remains small, PIMCO anticipates utilizing credit default swaps (CDS) or indexes of credit default swaps (CDX). The Bond Fund's benchmark is JP Morgan Global Bond Index, 50% hedged to Canadian dollars.
10. GCLP anticipates using CDX indexes for the Floating Rate Fund in order to transform the income from high yield bonds and debentures into income equivalent to or greater than that generated by short term floating rate instruments with a term less than 365 days.
11. CDX indexes are linked to the number of the most highly liquid CDS, and therefore permit quick and cost effective diversification to high yield and emerging market issuers. CDS have a similar risk profile to their reference entity (corporate or sovereign bonds), or in the case of a CDX, to an average of all the reference entities in the CDX index. The term of a credit default swap imparts credit risk similar to that of a bond of the reference entity with the same term. The Funds will not be able to achieve the same sensitivity to credit risk as the benchmark by using credit default swaps with a maximum term of 3 years. There is no term restriction in NI 81-102 when investing directly in the reference entities (corporate or sovereign bonds).
12. 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.
13. Both the interest rate swap market and the credit default swap markets are very large and liquid. The interest rate swap market is generally as liquid as government bonds and more liquid than corporate bonds. The Bank of International Settlements reports $207 trillion in interest rate swaps outstanding as of June 30, 2006. In Canada, there are close to $2 trillion of interest rate swaps outstanding, more than four times the federal and provincial debt.
14. CDS, on average, are highly liquid instruments. Single name CDS are slightly less liquid than the bonds of their reference entities, while CDS on CDX are generally more liquid, than corporate or emerging market bonds. The Bank of International Settlements reported $20.4 trillion in credit default swaps outstanding as of June 30, 2006. The International Swap and Derivatives Association's 2006 mid-year market survey estimated outstanding notional at $26 trillion. Using either source, the credit default swap market has surpassed the size of the equity derivatives markets, and is one of the fastest growing financial markets.
15. 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.
16. Credit risk exposure to a counterparty on an interest rate 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.
17. Potential credit exposure to a counterparty on a credit default swap on a CDX is equal to the notional exposure to any issuer in the index who has defaulted, or in the case of a single name CDS, equal to the full notional exposure. As is the case with interest rate swaps, this exposure is mitigated because the counterparty will be required to have an approved credit rating prescribed by NI 81-102, exposure to any individual counterparty is limited by NI 81-102.
18. 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 or could not be achieved as efficiently as 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
19. Section 2.8 of NI 81-102 requires that mutual funds cover their derivative positions with "cash cover".
20. 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.
21. 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.
22. The Funds desire to be able to use liquid Fixed Income Securities and floating rate evidences of indebtedness as cover for specified derivative transactions with respect to the Funds.
23. 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.
24. 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 Filer submits 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.
25. 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.
26. The Funds 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.
27. The Filer submits 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.
28. 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.
29. 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.
30. 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.
31. FRNs will have adequate liquidity and will otherwise meet the requirements for derivative transactions carried out in accordance with Section 2.8.
Using Put Options as Cover for Long Positions in Futures, Forwards and Swaps
32. 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.
33. 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.
34. 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 Filer submits that the Bond Fund 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
35. The Filer in conjunction with the portfolio manager, adopts a Statement of Investment Policies and Goals (the "Policy Statement") for each fund. The Policy Statement stipulates the risk management rules which are applied to the investment of the fund's portfolio, including: geographical and currency diversification; maximum holdings by issuer, by percentage of the fund and by industry, for an equity fund; rules regarding term to maturity and credit quality, for an income fund; and rules regarding the use of derivatives in the fund. The portfolio manager is required to provide investment advice in accordance with the Policy Statement, and to report any instances of failure to comply.
36. The Compliance and Investment Departments of the Filer and the Compliance Department of each portfolio manager oversees compliance with the Policy Statement by the portfolio manager. A formal Investment/Compliance reporting meeting takes place with representatives of the portfolio manager on a quarterly basis. As part of its reporting obligations to the Filer, each portfolio manager reports, among other things, on its use of derivatives. Such derivative use is overseen by the Investment Department of the Filer and by the Compliance Department of the portfolio manager. The Investment Department of the Filer reviews the Policy Statements, including the use of derivatives, on a regular basis, and considers any recommendations for changes from the portfolio manager. The Investment Department also considers the use of derivatives in conjunction with the rules contained in NI 81-102, and is responsible for applying trading limits or other controls, when necessary. Amendments to the Policy Statements must be approved by both the Filer and the portfolio manager. Risk measurement procedures or simulations to test the fund's portfolios under stress are not used.
37. The prospectus and annual information form of the Funds will include disclosure of the nature of the exemptions granted in respect of the Funds.
38. Without these exemptions, the Funds will not have the flexibility to enhance yield and to manage more effectively the exposures under specified derivatives.
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 held by each of the Funds 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) the Bond 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 the Bond 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) each of the Funds shall not enter into or maintain an interest rate swap position or credit default swap 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 or credit default 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 or credit default swap less the obligations of the Fund under such offsetting interest rate swap or credit default 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 or credit default swap.
(v) each of the Funds shall disclose the nature and terms of this relief in the Fund's prospectus under the Investment Strategies section and in the Fund's annual information form.