Easing Restrictions on the Stripping and Reconstitution of Government of Canada Bonds

The Department of Finance and the Bank of Canada, as its fiscal agent, work closely with financial market participants in the management of the federal government's debt program. From the government's perspective, maintaining a liquid well-functioning market in Government of Canada securities is a key factor in ensuring that debt-service costs are minimized. It is also of general benefit to other participants in the domestic fixed-income market, since Government of Canada securities are a key benchmark for pricing other fixed-income securities. This paper reviews one method for limiting the ability of market participants to exercise undue influence over the prices of individual securities by easing restrictions that limit the fungibility of coupon and principal cash flows in the market for stripped securities. The two restrictions considered include the current ceiling on reconstitution, which states that a bond may not be reconstituted beyond the amount originally issued, and the present non-fungiblility of interest and coupon payments. The authors examine the effectiveness of the alternatives, provide an analysis of the potential market and legal uncertainties that might arise, and finally include a brief review of the stripping practices in some other major government bond markets. The analysis suggests that the potential changes could constitute a useful approach for limiting the development of a squeeze in certain circumstances. These alternatives could, however, create uncertainty with regard to the actual amount outstanding of any given bond. They also raise some questions with respect to the tax treatment of fungible interest-principal payments, as well as questions about the potential for the manipulation of the market for other bonds. Moreover, a review of other major government bond markets reveals that restrictions, similar to those currently in force in Canada, also apply in the United States, the United Kingdom, and Germany.