By Foyston, Gordon & Payne Inc. | Jan. 17, 2024
Originally published Nov. 24, 2023

This article by Foyston, Gordon & Payne Inc. analyzes the effects of recent government interventions on the Canadian fixed-income market, focusing on changes to dividend taxation for financial institutions and the consolidation of Canada Mortgage Bonds (CMBs). It highlights the initial market fluctuations and subsequent reversals, emphasizing the need for a long-term perspective in navigating short-term volatility or “noise". 

Funds on the Canada Life™ shelf

Mutual funds: Canada Life Canadian Value Fund

We regularly advise many of our clients to ignore short-term noise in the markets and focus on the long term. This week, we have two concrete examples proving our point: the Canadian government made one partial U-turn and one complete U-turn just months after announcing two controversial proposals.

Exhibit A: Dividend taxation for financial institutions

In March, the federal government released its annual budget which included measures targeted at the financial industry. This news negatively affected the Canadian fixed income market in subsequent months.

The budget proposed changes to the taxation of dividends received on certain shares owned by financial institutions. The proposal would deny financial institutions the ability to claim a tax deduction on the dividends they receive. This announcement was followed by notable selling pressure on preferred shares by retail investors and modest selling pressure from institutional investors. Additionally, the proposed change lowered overall demand for preferred shares as insurance companies, which had been strong supporters of the asset class, decreased their participation in the market as they awaited further clarity from the government. We believe the selling pressure and reduction in demand have been major factors in the performance of preferred shares so far this year.

Moving forward to Tuesday’s fall economic statement, the federal government changed course by providing an exception to financial institutions in relation to taxable preferred shares. This development is clearly beneficial for preferred share demand. The market turned very positive as a result, a trend that we expect will continue.

Exhibit B: Issuance of Canada Mortgage Bonds (CMBs)

March’s federal budget also proposed consolidating Canada Mortgage Bonds (CMBs) into the government’s regular borrowing program, claiming cost savings. While this proposal would have implications for the mortgage market (access to mortgage financing, insurance costs, etc.), we are only going to address the material impact on the fixed income market.

This budget proposal led to differing opinions on what the change would ultimately mean for the outstanding CMBs in the Canadian market. The initial market reaction was tighter credit spreads on the outstanding bonds given the potential of direct government intervention.

However, as the market digested the budget proposal, the narrative surrounding CMBs changed. Most observers concluded that market liquidity would likely decrease on a permanent basis as CMBs would simply be phased out. This viewpoint resulted in credit spreads retracing their initial move and even widening out past where they had been trading prior to the announcement. Investors who had bought CMBs at the tighter levels likely faced mark-to-market losses. After this consolidation decision, the government received negative feedback from market participants.

Likely as a result of this feedback from investors, the federal government announced a reversal of the consolidation program in Tuesday’s fall economic statement. Furthermore, the government also decided to expand the CMB program while also planning to start purchasing CMBs for itself (for investment purposes). Consequently, spreads on CMBs have, so far, tightened because of these announcements.

Conclusion

These two developments highlight how short-term noise may impact fixed income markets. They were surprise announcements that drove gains and losses in the short term.

Announcements and policy changes that appear to be negative can easily be reversed. It is important not to over-react to short-term situations, but rather, to maintain a long-term perspective, understanding fundamental value, and to position investment portfolios in consideration of various outcomes in order to deliver strong risk-adjusted returns.

This document has been prepared for informational purposes only without regard to any particular investment objectives or financial situation and should not be construed as financial advice or as a solicitation, recommendation or offer to buy or sell any security, financial product or instrument. While the information included in this document is obtained from sources that FGP believes to be reliable, we do not guarantee its accuracy, and the information may be incomplete or condensed.

The views expressed in this commentary are those of this investment manager as at the date of publication and are subject to change without notice. This commentary is presented only as a general source of information and is not intended as a solicitation to buy or sell specific investments, nor is it intended to provide tax or legal advice.

The Canada Life Canadian Value Fund is available a mutual fund managed by Canada Life Investment Management Ltd. offered exclusively through Quadrus Investment Services Ltd., IPC Investment Corporation and IPC Securities Corporation. Make your investment decisions wisely. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated.

Canada Life and design and Canada Life Investment Management and design are trademarks of The Canada Life Assurance Company.