Investors who leaped into Basel-compliant bonds issued by Canadian banks to great fanfare are likely regretting their haste. A year on, the reward for taking on the risk of bailing out a bank has become much richer.
Relative yields of the bonds have widened 25 basis points this year, the worst performance among Canadian five-year corporate bonds, according to RBC Dominion Securities research. The debt is designed to convert to equity if a bank gets into financial distress, in line with new Basel rules to prevent another financial crisis. The first issue of the debt, called contingent capital bonds, in Canada was by Royal Bank of Canada in July, 2014.
"It's been out for a year and it hasn't performed that well," Altaf Nanji, who helps oversee $17-billion for Manulife Asset Management, said. "Overall expectations of supply are still significant and weighing on things."
Trading in the bonds suggests banks will have to pay fatter yields to attract investors to a market that BMO Nesbitt Burns estimates could eventually reach $25-billion to $30-billion. The notes would be converted to equity if Canada's bank regulator declares they're needed to keep a bank afloat, or if the bank is forced to seek government aid to keep operating.
The first non-viability contingent capital note to hit the market a year ago is trading at its widest gap to government peers since its issuance, according to data compiled by Bloomberg. The $1-billion note from Royal Bank of Canada was criticized in the week following its sale by the Canadian Bond Investors Association for not giving investors enough time for review. Yet it was still oversubscribed by almost five times.
In the past year, Canada's Big Six banks have issued $7.8-billion of contingent capital bonds – and by year-end, supply is forecast to grow to about $10-billion, according to RBC research. Toronto-Dominion Bank was the most recent issuer, pricing $1.5-billion of 10-year notes on June 18 at a yield of 166 basis points more than the equivalent government benchmark. By comparison, investors demand about 108 basis points to hold senior-ranking bank debt, according to Merrill Lynch. (A basis point is 1/100th of a percentage point.)
The gap between contingent and senior bank debt has grown to as much as 50 basis points, from 30 a year ago.
Elyse Lalonde, a spokeswoman for Royal Bank of Canada, didn't immediately respond to a request for comment on the bond performance.
The higher risks associated with contingent capital – they rank lower than senior notes because of the provision that they would be used to bail out a bank in trouble – means they pay higher yields than senior notes.
Canadian regulators require their banks maintain a total capital ratio of at least 11.5 per cent of total risk-weighted assets, although banks will typically buffer more, according to Kris Somers, an analyst at BMO Nesbitt Burns.
"Key factors contributing to the underperformance" include economic volatility and expectations for increased issuance, RBC analysts led by Robert Poole wrote in a July 6 note.
Since the July 11, 2014, 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 widened to 172 basis points. The average spread for Canadian corporate bonds is 136 basis points over governments, according to Merrill Lynch data.
Higher yields might tempt investors back, Manulife's Mr. Nanji said.
"Repricing certainly helps," he said. "We'll have to sit back and take another look at what the expectations are for supply."