Bank rescue plan may squeeze a corner of Canada’s bond market

Bloomberg

New rules to protect taxpayers from bank failures may push investors out of a C$95 billion ($75 billion) corner of Canada’s corporate bond market, reducing liquidity and raising borrowing costs.
Under a regime set to take effect in 2018, short-term bank-deposit notes typically sold to institutional investors will gradually be replaced by senior “bail-in” debt that can convert to equity in the event of a bank failure. The new instruments may be off limits to money-market investors who aren’t allowed to hold securities that risk being converted to equity, some analysts and money managers say.
The changes could cause friction in the C$310 billion money market that greases the wheels of corporate finance. Short-term investors scoop up deposit notes with less than a year left to maturity as longer-term investors sell. That helps keep the market liquid, allows banks to borrow at low rates and offers investors access to safe bonds that yield more than short-term government debt.
“What we don’t know is if there is going to be an impact to bank funding costs because there is not a wall of money market buying at one year,” according to Kris Somers, a credit analyst at BMO Capital Markets who follows Canadian banks.
The federal government and bank regulator are expected to release final guidelines for the bail-in regime before the end of the year, including how much debt and capital banks will need to hold to satisfy their total loss-absorbing capacity requirement, also known as the TLAC ratio. The framework is part of a global effort to prevent a repeat of the 2008 financial crisis, which saw taxpayers fund massive bailouts of banks. The potential wrinkle for Canadian money-market investors is due to an interpretation of existing securities law.
The draft rules say unsecured debt with a term of at least 400 days will be eligible for bail-in and that a security must have at least 365 remaining days to maturity to count toward a bank’s TLAC ratio. The TLAC ratio must be 21.5 percent of risk-weighted assets by Nov. 1, 2021. Currently the big five Canadian banks have an average TLAC ratio of 15 percent, according to Himanshu Bakshi, a Bloomberg Intelligence credit analyst.
About C$18.6 billion of existing deposit notes mature in the first half of 2018, according to a RBC Capital Markets report. If banks don’t issue deposit notes to replace them before the bail-in guidelines are finalized, they will be replaced by senior bail-in debt. The average spread on a five-year deposit note is about 71 basis points over government debt, according to RBC.
“We’re going to have fewer options to add yield to the portfolio,” Walter Posiewko, a money-market fund manager at RBC Global Asset Management, said by phone from Toronto. The fund likely won’t purchase the new senior bail-in debt because of the lack of clarity around securities regulation and liquidity concerns, choosing instead to buy other short-term bank debt such as banker’s acceptance and bearer deposit notes, he said.