Bank Rescue Plan May Squeeze a Corner of Canada Bond MarketBy
Money-market funds say can’t hold debt that converts to equity
‘We’re going to have fewer options to add yield,’ manager says
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.
The Office of the Superintendent of Financial Institutions, Canada’s bank regulator, has no intention of amending its guidelines to address the question, spokeswoman Annik Faucher said in an email. Current guidelines don’t prohibit investors from purchasing the debt, she said.
The Ontario Securities Commission and the Canadian Securities Administrators, an umbrella organization of provincial regulators, declined to comment.
The proposed bail-in rules are not intended or expected to result in significant changes to banks’ funding structures, including which investors buy the debt, Jocelyn Sweet, deputy spokesperson for Finance Canada, said in an email. The regulation does not prohibit particular types of investors from buying bail-in debt, she said.
Securities regulators will likely need to clarify whether rules governing money-market funds prohibit them from investing in bail-in bonds, even if they aren’t the same as traditional convertible debt, and the likelihood of a Canadian bank needing rescue is very low, Kashif Zaman, a partner in the financial services practice of Osler, Hoskin & Harcourt said by phone from Toronto.
“It’s really up to securities regulators to acknowledge or recognize whether they need to make an exception for this,” he said.