Bond buyers grab disappearing bank debt ahead of Canada bail-in

Bloomberg

Bond investors are snapping up Canadian bank debt that’s likely to start disappearing under new government rules expected early this year to protect taxpayers from having to bail out a failing financial firm. About C$100 billion ($75 billion) in deposit notes outstanding — senior unsecured bank debt valued for its credit quality, liquidity, and widespread inclusion in portfolios and bond indexes — is set to start being replaced at maturity this year by new “bail-in” senior debt that would convert to equity to stave off a bank failure. The impending shakeup, which may come by the end of February, is prompting bond investors to buy up existing deposit notes, particularly those who don’t know yet if they’ll be allowed to hold debt that converts to equity in their portfolios.
That’s sent prices of the notes surging, narrowing the yield over government debt to about 95 basis points for a five-year note, near post-2008 financial crisis lows, with room to shrink further, said Rohan Thiru at Canoe Financial LP.
“They can probably issue deposit notes for maybe another six months,” Thiru, a Toronto-based portfolio manager, said by phone. “There’s going to be scarcity value attached to them.”
Canada has been strengthening its bank capital rules in step with the global push to prevent a repeat of the financial crisis that saw governments around the world rescue several big banks from a liquidity crisis. Although the country never had a large-scale bail-out like the U.S. or Europe, the government offered support to banks through the crisis and as the market for securitized mortgages froze up.

Capital Cushion
In addition to adopting liquidity and capital standards set by global regulatory bodies including the Basel III committee and the Financial Stability Board, the Canadian government has been working on its own framework to force bank losses onto creditors instead of taxpayers. Those details could be released for comment as early as the end of February, according to a Bank of Montreal report.
The government doesn’t have a date set for the release of the rules, Finance Minister Bill Morneau said on Jan. 13. “We continue to see that it’s important to ensure our banking sector is strong and that Canadian consumers are protected,” he said during a news conference in Toronto. “As we have more, we will come forward.”
Bond investors are still waiting for the Department of Finance and the Office of the Superintendent of Financial Institutions, the bank regulator, to provide details on questions such as the parameters and transition period for issuance of bail-in debt, the conversion ratios for debt to equity in the event of a failure, and the capital cushion required of banks, analysts say.
Initial government guidance released in 2014 suggests that banks will be required to maintain a capital cushion of 17 percent to 23 percent of risk-weighted assets, according to David Beattie, a Moody’s Investors Service analyst in Toronto. That cushion would be in line with the total loss-absorbing capacity — the minimum capital requirement needed to resolve an insolvent bank — set by the Financial Stability Board for global systemically important banks in late 2015.
Issuance of bail-in debt, which is widely expected to start by the second half of the year, will count toward that capital cushion. Royal Bank of Canada estimates that banks will issue about C$25 billion ($19 billion) in deposit notes and new bail-in debt this year, according to a RBC Capital Markets report.
Bail-in debt is not the only capital that would be accountable for losses under the new regime. Canadian banks have already started issuing non-viability contingent capital (NVCC) subordinated debt and preferred shares, with C$13.9 billion in sales in 2016 and C$8.5 billion of global issuance expected this year, according to RBC.

Downgrade Pressure
Five-year NVCC sub-debt is trading about 90 basis points above deposit notes, a pickup that still looks attractive, according to Thiru.
Deposit notes have made up more than 30 percent of Canadian corporate issuance over the past five years, according to a Bank of Montreal BMO Capital Markets report. Issuance was about C$28 billion last year.
Toronto-Dominion Bank is Canada’s top-rated bank by Moody’s Investors Service with an Aa1 rating, one notch below the highest credit rating. The remaining big five banks are all rated two steps lower at Aa3. Moody’s has the Canadian banks under negative outlook in part due to the reduced likelihood of government support for the banks coming out of the bail-in regime, Moody’s Beattie said.
“It will certainly make a difference in the way we think about the banks,” he said. “There will be downward pressure on the Canadian bank ratings as a result of the bail-in regime.”

Rising Risk
But the tranche of bail-in debt that will absorb losses will build up over time and that will create structural support for the senior obligations, he said. The credit rating of banks may not change as a result. It’s expected that there will be a transition period of two to three years to allow banks to build up sufficient levels of capital and replace legacy senior debt as it matures with new bail-in debt, he said.
Although no one thinks a Canadian bank failure is likely, the nature of the banks have changed since 2008. They face with growing exposure to international business, rising unsecured loan, auto and credit card books, record consumer debt levels, and increased risks in the housing market, Thiru at Canoe said. These increased risks are driving officials to put together a plan, he said.
“Even though Canada did not get into trouble in 2009, banks have structurally changed since then,” Thiru said. “They realize they need to be a bit safer.”