Canada Gets Wake-Up Call on Hybrids as Great West Opts to Float

  • Insurer bucks tradition, investors may need to wait 30 years
  • Canada dollar-bond yields spike as traders wonder what's next

Canadian bond investors who thought they had about 30 days before the $300 million they lent insurer Great West Lifeco Inc. would be paid back came to work Monday to find it might take another 30 years instead.

Great West on April 15 opted not to exercise an option to payback one of its U.S. dollar bonds early. That means the money Great West borrowed in 2006 doesn’t have to be paid back until 2046, and -- because the interest goes from fixed- to floating-rate -- lenders face coupon payments being cut by more than half if market rates stay where they are.

Now investors are wondering if C$45 billion ($35 billion) more lent to the country’s financial sector could share the same fate.

"It’s a wake-up call," said James Dutkiewicz, who manages C$18 billion as chief investment strategist at Sentry Investments Inc. in Toronto, and owns some of Great West’s U.S. dollar notes. "Having a Canadian institution take advantage, on an economic basis of a floating rate, is the first."

Yields Jump

Investors say the move by Great West is a rare example of a Canadian financial institution opting not to exercise an early-call option on that kind of fixed-to-floating rate note. It has them wondering if the C$45 billion Canadians lent in their own country under similar terms might also lock buyers in much longer than they bargained for if the floating rate starts to look like a better deal than what a company could get if it borrowed fresh today.

Investors’ fears are manifesting themselves in the market where bonds, originally priced assuming they’d be called, are adjusting to the possibility of the longer term. Great West’s U.S. dollar note saw the yield investors demand to hold it to the call date almost triple after the insurer opted not to call, according to data compiled by Bloomberg.

Another Great West note, this one denominated in Canadian dollars with a year to go before its call date, saw its yield to the call date go from 2.4 percent to 7.1 percent as investors increased the odds it could be extended as well. If it isn’t called, those C$1 billion in notes don’t have to be paid back until 2067.

"Canadian investors never believed a Canadian bank or issuer would do that kind of thing in Canada," Marc Goldfried, who manages C$3.5 billion as chief investment officer at Canoe Financial LP in Toronto.

‘Risk Factor’

"Now they have demonstrated to the marketplace they will make a decision that is right for the income statement and balance sheet," he said. "So it does create a risk factor on those other Great West bonds, and should create a risk factor on any Canadian company with this kind of debt outstanding."

Though there are examples in the U.S. of companies opting not to call these hybrid notes, the convention in Canada that these fixed-to-floating rate notes would always be called helped keep borrowing costs low, and its breakdown could see those costs rise, Goldfried said.

"When companies within the Lifeco group make decisions on capital and capital instruments, they do so on a case-by-case basis for each specific capital instrument under consideration," said Great West spokeswoman Marlene Klassen in a statement.

‘Their Option’

For Great West, extending the notes for the next 30 years is a bet that the floating rate they agreed to a decade ago is better than what they can get now. That rate is the London inter-bank offered rate for the U.S. dollar, which stands at around 0.63 percentage points and is updated daily, plus 2.54 percentage points. That compares to an average borrowing cost of 4.66 percent faced by insurers and financial companies to borrow for more than 10 years in the U.S. now, according to Bank of America Merrill Lynch data.

"They didn’t do anything wrong," said Mike Temple, a bond trader at Piper Jaffray & Co. in New York. "They just made the rational, economic decision to choose not to redeem the security. They don’t have to, it’s their option."

Though borrowing costs globally have risen from all-time lows, they remain historically depressed, making it more tempting for companies to gamble on the floating rate. New rules since the 2008 financial crisis, requiring explicit language in bond contracts outlining how new debt will be turned into equity if the financial institution gets into trouble, have also made those securities more expensive.

This may cause banks and insurers to opt for the floating-rate conversion negotiated before, even as rates rise, according to Sentry’s Dutkiewicz. If that means inflicting losses on bondholders, however, the firm may pay for it next time they borrow.

"They have to continually tap the market," he said. "You don’t want to annoy a bunch of big holders of paper who will not support your next issue because you didn’t call the paper."

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