Royal Bank of Canada’s offering of C$1 billion ($930 million) in subordinated debt is likely to be the first of about $25 billion in sales over the next decade by Canadian lenders seeking to meet Basel III capital requirements.
The sale of non-viability contingent capital bonds was the first attempt by a Canadian bank to meet new regulations through subordinated debt that converts to equity if a lender gets into financial distress. Toronto-based Royal Bank priced the 3 percent notes on July 11.
Lenders need to sell the notes in part because regulations designed to make banks safer mean they must phase out older forms of subordinate debt that didn’t convert into equity. The NVCC debt complies with international banking standards aimed at preventing a repeat of the 2008 financial crisis.
“It’s a phase-in for the new form and a phase-out for the old legacy debt,” David Beattie, senior credit officer at Moody’s Investors Service, said by phone yesterday from Toronto. “New leverage calculations are much more restrictive” and exclude traditional types of subordinate debt from capital cushions, he said.
Canadian regulators require their banks maintain capital equivalent to at least 11.5 percent of total risk-weighted assets, although banks will probably set aside more than that as a buffer, according to George Lazarevski, a credit analyst in Toronto at Bank of Montreal’s BMO Capital Markets.
Taking into account issuance of all securities designed to absorb losses, including preferred shares, banks could issue C$49 billion of securities to comply with Basel III, Lazarevski said. The market for subordinated bonds may increase to C$26 billion in Canada, he said.
Royal Bank’s issue was the first by a Canadian bank that is considered non-viability contingent capital by regulators, according to John van Boxmeer, an analyst at DBRS Ltd., which rated the debt A (low), four levels below the bank’s senior rating of AA. Moody’s rated the securities Baa1, four levels lower than the bank’s senior rating of Aa3. Standard & Poor’s rates the debt A-, compared with its senior rating of AA-.
“It has performed reasonably since pricing, but it is not a cheap security,” Ed Devlin, who oversees $17 billion for Pacific Investment Management Co., said in an e-mail yesterday. He declined to say if he bought the notes. “It’s in line with the rest of the expensive Canadian corporate market.”
In Europe, where issuance began 14 months ago, the outsized coupons on subordinated bonds have stoked unprecedented investor demand for the securities, boosting the total market to $94 billion, according to data compiled by Bank of America Merrill Lynch. The average rate European lenders pay to raise is 7.2 percent, according to Merrill Lynch, compared with the 3 percent investors in Royal Bank of Canada’s issue will get until July 2019, when the debt can be redeemed.
“Historically, the Canadian capital market has felt pretty good about its banks, so it’s willing to invest at tight spreads,” DBRS’s van Boxmeer said by phone from Toronto. “The likelihood of a trigger event is extremely remote.”
The notes would be converted to equity if Canada’s bank regulator declared they are needed to restore a bank’s viability, or the bank is forced to seek government aid to keep operating.
Since the July 11 sale at a yield of 152 basis points, or 1.52 percentage points, more than Canadian government debt, the spread on the Royal Bank bonds has narrowed to about 147 basis points, according to Bloomberg data.
“Canadian banks are of too high a quality to get a juicy coupon on NVCC,” James Dutkiewicz, fund manager and chief investment strategist at Sentry Investments Inc., said by phone yesterday from Toronto. He said he didn’t buy the Royal Bank bonds last week. “My guess is that all else being equal, the next deals will be marginally tighter in spread.”