National Policy 11-203 Process for Exemptive Relief Applications in Multiple Jurisdictions -- exemption from section 2.7 (1)(a) of NI 81-102 to permit interest rate and credit derivative swaps and currency forwards 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: certain bonds, debentures, notes or other evidences of indebtedness, and money market funds -- 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 -- exemption from section 2.1(1) of NI 81-102 to permit global bond mutual funds to investment more than 10 percent of net assets in debt securities issued by a foreign government or supranational agency.
Applicable Legislative Provisions
National Instrument 81-102 Mutual Funds, ss. 2.1(1), 2.7(1), 2.8(1).
July 29, 2011
IN THE MATTER OF
THE SECURITIES LEGISLATION OF
IN THE MATTER OF
THE PROCESS FOR EXEMPTIVE RELIEF
APPLICATIONS IN MULTIPLE JURISDICTIONS
IN THE MATTER OF
MANULIFE ASSET MANAGEMENT LIMITED
IN THE MATTER OF
THE MUTUAL FUNDS NOW (the Existing Funds)
OR IN THE FUTURE (the Future Funds, together
with the Existing Funds, the Funds), OTHER
THAN MONEY MARKET FUNDS, MANAGED BY
THE MANAGER OR AN AFFILIATE OR A
SUCCESSOR OF THE MANAGER THAT ARE
SUBJECT TO NATIONAL INSTRUMENT 81-102
MUTUAL FUNDS (NI 81-102) (the Funds together
with the Manager, the Filers)
The principal regulator in the Jurisdiction has received an application from the Filers for a decision under the securities legislation of the Jurisdiction of the principal regulator (the Legislation) for an exemption relieving the Funds from the sections of NI 81-102 as follows:
(a) the requirement in section 2.7(1)(a) of NI 81-102, in order to permit the Funds to enter into interest rate swaps or credit default swaps and, if the transaction is for hedging purposes, currency swaps and forwards, in all cases with a remaining term to maturity of greater than three years;
(b) the requirement in section 2.8(1) of NI 81-102 in order to permit each of the Funds to cover specified derivative positions with:
(i) any bonds, debentures, notes or other evidence of indebtedness that are not illiquid assets (as defined in NI 81-102) (collectively, Fixed Income Securities) provided they have a remaining term to maturity of 365 days or less and have approved credit rating;
(ii) floating rates evidences of indebtedness; or
(iii) securities of money market funds (as defined in NI 81-102) managed by the Manager;
(c) the requirement in sections 2.8(1)(d) and 2.8(1)(f)(i) of NI 81-102 in order to permit each of the Funds when it
(i) 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
(ii) enters into or maintains a swap position and during the periods when the 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;
(d) the requirement in section 2.1(1) in order to permit Manulife Strategic Income Fund, Manulife Strategic Income Class, Manulife Emerging Markets Debt Fund, Manulife Asia Total Return Bond Fund and all future global and/or international bond funds managed by the Manager (the Bond Funds) to invest:
(i) up to 20% of its net assets in securities issued or guaranteed as to principal and interest by any government or agency thereof (other than a government or agency of Canada or a province thereof or of the United States, in which investment by all of the Funds is unrestricted) or any permitted supranational agency (as defined in NI 81-102), provided that the securities have a minimum AA rating by Standard & Poor's Rating Service or the equivalent rating by any other rating agency listed in NI 81-102;
(ii) up to 35% of its net assets in securities issued or guaranteed as to principal and interest by any government or agency thereof (other than a government or agency of Canada or a province thereof or of the United States, in which investment by all of the Funds is unrestricted) or by any permitted supranational agency (as defined in NI 81-102), provided that the securities have a minimum AAA rating by Standard & Poor's Rating Service or the equivalent rating by any other rating agency listed in NI 81-102;
provided that sub-paragraphs (i), and (ii) of this paragraph (e) cannot be combined for any one issuer.
Paragraph (a) is referred to as the Swap and Currency Derivatives Requested Relief, paragraph (b) is referred to as the Fixed Income, FRN and Money Market Fund Cover Requested Relief, paragraph (c) is referred to as the Put Option Cover Requested Relief, and paragraph (d) is referred to as the Sovereign Government and Supranational Entity Concentration Requested Relief, and collectively, the Swap and Currency Derivatives Requested Relief, the Fixed Income, FRN and Money Market Fund Cover Requested Relief, the Put Option Cover Requested Relief and the Sovereign Government and Supranational Entity Concentration Requested Relief shall be referred to as the Requested Relief.
Under the Process for Exemptive Relief Applications in Multiple Jurisdictions (for a passport application):
(a) the Ontario Securities Commission is the principal regulator for this application, and
(b) the Filer has provided notice that section 4.7(1) of Multilateral Instrument 11-102 Passport System (MI 11-102) is intended to be relied upon in each of the provinces and territories of Canada other than the province of Ontario.
Terms defined in National Instrument 14-101 Definitions and MI 11-102 have the same meaning if used in this decision, unless otherwise defined.
This decision is based on the following facts represented by the Filers:
Manulife Asset Management Limited
1. The Manager is the manager, portfolio advisor and/or trustee of the Funds. The Manager is a corporation governed under the Business Corporations Act (Ontario) and has its head office located in Toronto, Ontario. The Manager is an indirect wholly-owed subsidiary of Manulife Financial Corporation (Manulife Financial).
2. The Manager is registered in the categories of portfolio manager, investment fund manager, exempt market dealer, mutual fund dealer and commodity trading manager.
3. Manulife Financial is a leading Canadian-based financial services group operating in 22 countries and territories worldwide. Founded in 1887, Manulife Financial offers financial protection and wealth management products and services to clients. It also provides asset management services to institutional customers worldwide as well as reinsurance solutions, specializing in life and property and casualty retrocession. Manulife Financial and its subsidiaries managed CDN$478 billion of funds as at March 31, 2011.
4. To the knowledge of the Manager, the Manager and the Funds are not in default of securities legislation in any jurisdiction.
5. All of the Funds are reporting issuers and are subject to the requirements of NI 81-102. Future Funds may be trusts or shares of mutual fund corporations.
6. The investment objectives and strategies of each Fund are set out in the Fund's simplified prospectus.
7. The Funds, other than Manulife Canadian Growth Fund, are currently permitted to use specified derivatives to hedge against losses caused by changes in securities prices, interest rates, exchange rates and/or other risks. These Funds may also use specified derivatives for non-hedging purposes under their investment strategies in order to invest indirectly in securities or financial markets or to gain exposure to other currencies, provided the use of specified derivatives is consistent with the particular Fund's investment objective. When specified derivatives are used for non-hedging purposes, the Funds are subject to the cover requirements of NI 81-102.
Extended Term to Maturity for Interest Rate Swaps, Credit Default Swaps and currency Swaps or Forwards
8. Paragraph 2.7(1)(a) of NI 81-102 prohibits mutual funds from entering into swaps or currency forwards 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 Manager seeks the ability to enter into interest rate swaps or credit default swaps for the Funds or, if the transaction is for hedging purposes, currency forwards on behalf of the Funds, in either case without a restriction as to term of the swap or forward.
9. Fixed income investments have risks which include (but are not limited to) interest rate risk, credit risk and currency risk. These risks can be controlled or mitigated through the use of over-the-counter (OTC) derivatives. Interest rate risk may be managed by interest rate swaps, credit risk may be managed by credit default swaps and currency risk by currency swaps or forwards.
10. The term of a swap equals the maturity of its exposure, in contrast to other OTC derivatives transactions, such as options and certain other types of 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 referencing an underlying interest having a term of 10 years whereas there is a restriction if the derivative is in the form of a swap.
11. In order to achieve diversification at a reasonable cost, the Manager or a portfolio sub-advisor to a Fund may use credit default swaps (CDS) on indexes of credit default swaps (CDX). CDX indexes are linked to a number of the most highly liquid CDSs, and therefore permit quick and cost effective diversification to high yield and emerging market issuers.
12. CDSs 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 CDS 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 their underlying benchmarks by using CDSs with a maximum term of 3 years because their underlying benchmarks may have an average term of greater than 3 years. There is no term restriction in NI 81-102 when investing directly in the reference entities (corporate or sovereign bonds).
13. A currency swap or forward used for hedging purposes may or may not have a contract term and maturity that equals the maturity of the underlying interest. For example, if a 10-year bond is denominated in U.S. dollars, under the current provisions of NI 81-102, the term of the currency forward can be at most 5 years whereas the term of the underlying interest is 10 years. As a result, to manage the currency risk, a fund must enter into two consecutive 5-year currency forwards. However, the pricing for the currency swap or forward in respect of the second 5-year period is not known at the time the U.S. dollar bond is purchased but only 5 years hence. Consequently, the inability to enter into a 10-year currency swap or forward transaction indirectly introduces currency risk when a hedged 10-year position was the desired outcome. Accordingly, whenever the term of the bond is longer than 5 years, the current provisions of NI 81-102 may unintentionally expose a fund to additional currency risk. This has become a very relevant issue given that there are no longer foreign investment restrictions under the Income Tax Act (Canada).
14. It is also not market convention to have a transaction with a 5-year term (subject to a right to eliminate the exposure within 3 years) as required by NI 81-102 and, as a result, from time to time, this off-market feature may subject a fund to less efficient pricing.
15. The interest rate swap market, CDS markets and currency forward and swap markets are very large and liquid.
16. Although there is no exchange through which swap and forward contracts are traded, there is a very active OTC market in these contracts that provides significant liquidity for participants in this market. In order to unwind a position, a counterparty could find a new counterparty willing to take over its contract at a fair market price and get the other counterparty to approve the new counterparty. Market participants can also unwind their positions in interest rate swaps and currency swaps or forwards by simply closing out the swap or forward with the counterparty at market value. In the case of CDSs, the counterparty can either close out the CDS with the counterparty at market value or it can trade with another counterparty by assigning the swap to the other counterparty (with the consent of the original counterparty).
17. Credit risk exposure to a counterparty on interest rate swap transactions is generally a small fraction of the underlying notional exposure, equal to the cumulative price change since the inception of the swap. However, even such small risk will be mitigated in the contemplated transactions of the Funds as the counterparty will be required to have an approved credit rating prescribed by NI 81-102.
18. Potential credit exposure to a counterparty on a CDS or 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 and exposure to any individual counterparty is limited by NI 81-102.
19. The ability of the Funds to enter into swaps and forwards that have terms beyond 3 years would provide the Funds with a broader selection of investment opportunities and to target exposures 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, the use of swaps and forwards with terms beyond 3 years would enable the Funds to effect hedging transactions that are more efficient and tailored to the risks being hedged and to a Fund's particular needs.
Using Fixed Income Securities, Floating Rate Debt and Money Market Funds as Cover
20. The purpose of the cash cover requirement in NI 81-102 is to prohibit a mutual fund from leveraging its assets when using certain specified derivatives and to ensure that the mutual fund is in a position to meet its obligations on the settlement date. This is evident from the definition of "cash cover", which is defined as certain specific portfolio assets of the mutual fund that have not been allocated for specific purposes and that are available to satisfy all or part of the obligations arising from a position in specified derivatives held by the mutual fund. Currently, the definition of "cash cover" includes six different categories of securities, including certain evidences of indebtedness (cash equivalents and commercial paper) that generally have a remaining term to maturity of 365 days or less and that have an approved credit rating or are issued or guaranteed by an entity with an approved credit rating (collectively, Short-term Debt).
21. In addition to the securities currently included in the definition of cash cover, the Funds would also like to invest in Fixed Income Securities floating rate evidences of indebtedness and/or securities of money market funds (as defined in NI 81-102) managed by the Manager for purposes of satisfying their cash cover requirements.
Cover in the form of Fixed Income Securities
22. While the money market instruments that are currently permitted as cash cover are highly liquid, these instruments typically generate very low yields relative to longer dated instruments and similar risk alternatives.
23. Other fixed income securities with remaining terms to maturity of less than 365 days and approved credit ratings are also highly liquid but provide the potential for higher yields.
24. The definition of cash cover addresses regulatory concerns of interest rate risk and credit risk by limiting the terms of the instruments and requiring the instruments to have an approved credit rating. It is submitted that by permitting the Funds to use for cash cover purposes Fixed Income Securities with a remaining term to maturity of 365 days or less and an approved credit rating, the regulatory concerns are met, since the term and credit rating will be the same as other Short-term Debt instruments currently permitted to be used as cash cover.
Cover in the form of Floating Rate Evidences of Indebtedness
25. Floating rate evidences of indebtedness, also known as floating rate notes (FRNs), are debt securities issued by the federal or provincial governments, the Crown or other corporations and other entities with floating interest rates that reset periodically, usually every 30 to 90 days. Although the term to maturity of FRNs can be more than 365 days, the Funds propose to limit their investment in FRNs used for cash cover purposes to those that have interest rates that reset at least every 185 days.
26. Allowing the Funds to use FRNs for cash cover purposes could increase the rate of return earned by each of the Fund's investors without reducing the credit quality of the instruments held as cash cover. The frequent interest rate resets mitigate the risks of investing in FRNs as cash cover. For the purposes of money market funds under 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. 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.
27. Financial instruments that meet the current cash cover requirements 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 used by the Funds for cash cover purposes will have an approved credit rating as required by NI 81-102.
28. Given the frequent interest rate resets, the nature of the issuer and the adequate liquidity of FRNs, the risk profile and the other characteristics of FRNs are similar to those of Short-term Debt, which constitute cash cover under NI 81-102.
Cover in the form of Money Market Funds
29. Under NI 81-102, in order to qualify as money market funds, the money market funds are restricted to investments that are, essentially, considered to be cash cover. These investments include floating rate evidences of indebtedness if their principal amounts continue to have a market value of approximately par at the time of each change in the rate to be paid to their holders.
30. If the direct investments of the money market funds would constitute cash cover under NI 81-102 (assuming that the relief allowing FRNs as cash cover is granted), then it is submitted that indirectly holding these investments through an investment in the securities of money market funds managed by the Manager should also satisfy the cash cover requirements of NI 81-102.
Cover in the form of Put Options for Long Positions in Futures, Forwards and Swaps
31. 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.
32. 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 and as a result overcollateralization imposes a cost on a fund.
33. Section 2.8(1)(c) of NI 81-102 permits a mutual fund to write a put option and cover it with 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 Manager submits, 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
34. The Manager, in its capacity as manager and portfolio advisor, sets and reviews the investment objectives and overall investment policies of the Funds, which generally will allow for trading in derivatives. The derivative contracts entered into by or on behalf of the Funds must be in accordance with the investment objectives and strategies of each of the Funds and in compliance with NI 81-102.
35. The Manager in its capacity as portfolio advisor is generally permitted to use derivatives for the Funds under certain conditions and limitations in order to gain exposure to financial markets or to invest indirectly in securities or other assets. The Manager, in its capacity as portfolio advisor, may similarly allow any portfolio sub-advisors to use derivatives.
36. The Manager, in its capacity as portfolio advisor, currently has in place policies and procedures to manage the risks associated with derivatives trading. Any portfolio sub-advisor to the Funds would be required to have similar appropriate policies and procedures.
37. The simplified 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.
Sovereign and Supranational Debt
39. The concentration restriction under section 2.1 of NI 81-102 (the Concentration Restriction) prevents a fund from purchasing a security of an issuer or entering into a specified derivatives transaction, if immediately after the transaction, more than 10 percent of the net assets of such fund would be invested in securities of any issuer.
40. The Concentration Restriction does not apply to a purchase of a "government security", which, under NI 81-102, means an evidence of indebtedness issued, or fully and unconditionally guaranteed as to principal and interest, by any of the government of Canada, the government of a jurisdiction or the government of the United States of America.
41. Prior to the adoption of the Euro, there were greater diversification opportunities as the European debt markets comprised several currency-denominated issuers (including well developed and liquid markets for Lira, Franc, and Mark issued debt securities), each impacted by national government monetary policies. In contrast, today the European debt markets are dominated by Euro-currency denominated debt which comprises approximately 40% of the world government bond market and the coordinated monetary policy followed by the members of the European Union has effectively reduced diversification opportunities.
42. The Manager believes that the exemption sought will be in the best interests of the Bond Funds for the following reasons:
a. it will provide more flexibility and more favourable prospects for the Bond Funds because the Bond Funds will be better able to compose a global fixed income portfolio that will best achieve its investment objectives;
b. in certain jurisdictions, the securities of supranational agencies or governments may be the only liquid or rated debts available for investment; and
c. higher concentration limits may allow the Bond Funds to benefit from investment efficiencies and reduced transaction costs as certain foreign government treasury offerings are more readily available for investment and trades can be completed faster in certain markets that are more readily accessible to foreign investment.
The principal regulator is satisfied that the decision meets the test contained in the Legislation for the principal regulator to make the decision.
The decision of the principal regulator under the Legislation is that the Requested Relief is granted provided that:
1. in the case of the Fixed Income, FRN and Money Market Fund Cover Requested Relief:
a. 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;
b. the FRNs meet the following requirements:
i. the floating interest rates of the FRNs reset no later than every 185 days;
ii. 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;
iii. 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;
iv. 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
v. the FRNs meet the definition of "conventional floating rate debt instrument" in section 1.1 of NI 81-102;
c. the money market funds meet the definition of money market funds in NI 81-102;
2. in the case of the Put Option Cover Requested Relief:
a. when a Fund enters into or maintains a swap position for periods when the Fund would be entitled to receive fixed payments under the swap, the Fund holds:
i. cash cover, Fixed Income Securities or FRNs (collectively, 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;
ii. a right or obligation to enter into an offsetting swap on an equivalent quantity and with an equivalent term and 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 swap less the obligations of the Fund under such offsetting swap; or
iii. a combination of the positions referred to in clauses (a) and (b) that is sufficient, without recourse to other assets of the Funds, to enable the Funds to satisfy its obligations under the swap; and
b. when a Fund 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, the Fund holds:
i. cash cover, Fixed Income Securities or FRNs (collectively, 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;
ii. a right or obligation to sell an equivalent quantity of the underlying interest of the future or forward contract, and Cover that together with margin on account for the position, is not less than the amount, if any, by which the price of the future or forward contract exceeds the strike price of the right or obligation to sell the underlying interest; or
iii. 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;
c. a Fund will not (i) purchase a debt-like security that has an option component or an option, or (ii) purchase or write an option to cover any positions under section 2.8(1)(b), (c), (d), (e) and (f) of NI 81-102, if immediately after the purchase or writing of such option, more than 10% of the net assets of the Fund, taken at market value at the time of the transaction, would be in the form of (1) purchased debt-like securities that have an option component or purchased options, in each case, held by the Fund for purposes other than hedging, or (2) options used to cover any positions under section 2.8(1)(b), (c), (d), (e) and (f) of NI 81-102;
3. in the case of the Swap and Currency Derivatives Requested Relief, the Fixed Income, FRN and Money Market Fund Cover Requested Relief, and the Put Option Cover Requested Relief (collectively, the Derivatives Relief), each of the Funds shall disclose the nature and terms of the Derivatives Relief in the Fund's simplified prospectus under the investment strategies section and in the Fund's annual information form;
4. in the case of the Sovereign Government and Supranational Entity Debt Concentration Requested Relief:
a. the securities that are purchased pursuant to the Sovereign Government and Supranational Entity Debt Concentration Requested Relief are traded on a mature and liquid market;
b. the acquisition of the securities purchased pursuant to the Sovereign Government and Supranational Entity Debt Concentration Requested Relief is consistent with the fundamental investment objective of each Bond Fund;
c. the simplified prospectus of the Bond Fund discloses the additional risks associated with the concentration of net assets of the Bond Funds in securities of fewer issuers, such as the potential additional exposure to the risk of default of the issuer in which the Bond Fund has so invested and the risks, including foreign exchange risks, of investing in the country in which that issuer is located; and
d. the simplified prospectus of the Bond Funds discloses, in the investment strategy section, the details of the Sovereign Government and Supranational Entity Debt Concentration Requested Relief along with the conditions imposed and the type of securities covered by this relief.