If safety of principal is the dominant concern for an investor, bonds issued by the Government of Canada are a solid choice.
But if the investor’s objective includes both safety of principal and a slightly higher yield, an investment in Canada mortgage bonds may fit the bill.

Canada mortgage bonds are relatively new. They were first issued in the summer of 2001 by Canada Housing Trust, a single-purpose entity that is part of Canada Mortgage and Housing Corp. In its first issue, it sold $2.2 billion worth of the bonds, or about 50% more than originally anticipated. Since then, another $53 billion of CMBs have been issued. The first issue matures in June 2006.

With CMBs, investors receive fixed-interest payments every six months, plus the repayment of their principal at maturity. So far, all the outstanding bonds have been issued with terms of five years.

Typically, the bonds are priced to yield nine
to 11 basis points more than the yield on comparable Government of Canada bonds.
Over time, the add-on has narrowed
because of the popularity of CMBs and the demand they have generated among institutional investors.

In building the market in mid-2001, CHT issued CMBs with a yield equivalent to Canadas plus 15 bps. Its most recent issue — which raised $5.45 billion — had a 11.9 bps spread over Canadas. That bond, which was issued this past December will yield 3.78% if held to maturity.

At the same time, CHT raised $800 million via an offering of floating-rate notes that were priced to yield bankers’ acceptances plus three bps. This marks the first time CHT has issued floating-rate bonds and is part of its plan to expand the market with different types of offerings. The trust is looking at other products, such as U.S.-dollar bonds, or securities with maturities other than five years.

In addition to the enhanced return, CMBs are attractive because CMHC guarantees timely payment of principal and interest. As a result, these bonds are often regarded as credits of the Government of Canada itself — the highest credit available in the market — with the added sweetener of slightly higher returns.

“On a relative basis, Canada mortgage bonds are the cheapest bond out there,” says Michael Herring, managing director and fixed-income strategist at BMO Nesbitt Burns Inc. in Toronto. “An investor is getting an AAA-rated credit. That’s a liquid issue, and with a yield of about 10 bps more than investors get for buying Government of Canada bonds. It’s a good deal.

“In my view, they will be the future benchmark bonds,” he adds, noting that, because of the extra yield, “investors should avoid Government of Canada bonds in favour of Canada mortgage bonds.”

Adrian Mastracci, president of KCM Wealth Management Inc., a Vancouver-based fee-only financial planning firm, says CMBs have a place in a client’s portfolio. In addition to safety of principal and interest flows, “CMBs also offer diversification because each issue contains thousands of underlying mortgages. Diversification is a client’s best friend,” he says.

For an investor with a portfolio split equally between equities and debt, he suggests 5%-10% of the overall portfolio — or 10%-20% of the debt component — could be invested in CMBs “provided the risk parameters are acceptable to the client,” he adds.

The creation of CHT and CMBs came about as part of CMHC’s plan to provide a secondary mortgage market in Canada and to reduce the cost of mortgage financing.
The latter benefit has already occurred, given that CHT can raise debt capital of the same term at a lower rate than traditional financial institutions. In turn, those savings can be passed on to the consumer — meaning lower mortgage rates.

CMBs are sold to institutional and retail investors by CHT to finance its purchase of mortgage-backed securities issued by various financial institutions.
Mortgage-backed securities are investments backed by federally insured residential mortgages that have been pooled by financial institutions.

Investors who purchase the CMBs get paid both interest and principal from the payment flows on the underlying mortgages. But some financial engineering is required to accomplish this, given that payments on the underlying mortgages are made on a monthly basis and that the bond investors receive an interest cheque every six months and the return of their principal at maturity.