Case study: a Canadian mortgage lender

Background to the investment case

A Canadian mortgage lender issued a senior unsecured coupon bond in May 2014, which would mature after three years. Near maturity, the Ontario Securities Commission (OSC) issued enforcement notices against the firm over allegations of misrepresenting public disclosures. The firm’s investment-grade credit rating (BBB/BBB(H)) was put on negative watch on 30 March 2017 and the OSC escalated its investigation shortly after. Allegedly, the company had experienced broker-related fraud earlier due to lapses in risk management. The company conducted an internal investigation after becoming aware of discrepancies in income verification information submitted by its mortgage brokers; however, this information was allegedly not disclosed to the public in a timely manner.

ESG factor which drove the investment decision

Manulife Asset Management’s Canadian fixed income team began to materially reduce their exposure to the company in the last quarter of 2016 as awareness grew that the company was not handling discussions with the regulator well. The team’s view was that it was not uncommon for a company to disagree with a regulator but that the handling of the regulatory environment could play an important role in determining how large an issue could become.

At the end of March 2017, the company’s chief executive left unexpectedly and the regulator began escalating its investigation. Growing concern with the company’s approach to managing the regulatory investigation, coupled with increased regulation for Canadian residential mortgages due to an over-heated housing market, led the team to enter into a second stage of exposure reduction, liquidating positions fully in April 2017 in the specialised lender at prices above par. The team recognised that there was a high risk that the lender’s credit profile would deteriorate. As the situation worsened, the company experienced a run on deposits and by early May its credit ratings declined from solid-BBB to weak-B levels and bond prices correspondingly fell well below par.

In early May, Manulife Asset Management’s head of credit research examined the aforementioned bond – now very close to maturity and pricing well below par – and found that the market had overreacted to the corporate governance and regulatory concerns. Old management had been removed and this made the team more comfortable with the company’s corporate governance. The incoming CEO had solid experience in the banking sector and signalled to the market that the issue would be quickly resolved with the regulator. These changes, together with the line of credit secured by the company, was viewed positively by the team. They took the view that the emergency line of credit was to secure liquidity to pay off the maturing bonds rather than begin bankruptcy negotiations.

While the team did not previously own this particular bond, the head of credit research made a buy recommendation to the team based on the following conclusions:

• Base scenario: the company would remain a going concern through the maturity date of the 2017 bonds and would have ample liquidity to repay the principal amount.
• Best case: the company would be sold to an organisation which had sufficient financial strength to alleviate its short-term funding issues. This would see the 2017 notes migrate towards par earlier than the actual maturity date.
• Worst case: a worst case scenario would involve the company being deemed insolvent prior to the maturity of the 2017 notes and being placed into receivership. The primary risk in this scenario would involve the company defaulting on payment, with the subsequent recovery taking time, thereby negatively impacting projected returns.

The Canadian fixed income team proceeded with the recommendation (see Figure 41). Over time, the company navigated through the period of stress and remains a going concern.

Market implications

Key takeaways

The investment case highlights that careful consideration of governance and regulatory factors in fundamental analysis can help market participants to better price risk, which can lead to a reduction in exposure during periods of uncertainty or the addition of an exposure buy when the market has overreacted to these factors.