With a reputation for strength, Canadas financial institutions are prized by investors and adored by syndicate bankers. When the European bond markets are having a down day, it is not uncommon to hear a FIG syndicator wish for a really strong issuer, like an Australian, Nordic, or Canadian, to re-open the market.
The reasons they are held in such high regard are well known: they have strong capital ratios, needed no bail-outs during the crisis, and have non-performing loan rates that you need a microscope to find. And while only one borrower still has a triple-A rating, the big five banks all have at least two double-A ratings.
But Canadas FIG market has not escaped the turmoil that has buffeted global markets this year.
As debt markets both in Europe and the US have been hammered by sovereign debt worries this year, the Canadian market has also suffered.
"Overall market conditions have been challenging this year," says Peter Walker, associate vice president in treasury and balance sheet management at Toronto-Dominion Bank. "Theres been volatility in the market. The windows of ideal conditions for issuance have tended to be quite short, and weve had to capitalise on those opportunities while they were there."
And at the same time, ratings agencies have begun warning over consumer leverage, and the potential implications for banks non-performing loan rates.
Overlooking Canadas banking system is the Office of the Superintendent of Financial Institutions, a regulator with a reputation for being forward looking and for consulting thoroughly with the industry. In August, it was the first regulator internationally, for example, to lay down guidelines on non-viability rules under Basel III, clarifying when new-style capital instruments would write down or convert to equity. While that gave banks around the world an indication of regulatory thinking, it clarified the rules entirely for the domestic banks.
"Canada has a knowledgeable and proactive regulator," says Brenda Lum, managing director for Canadian financial institutions at DBRS in Toronto.
"The regulator has been actively moving on implementing the new rules, and has been very collaborative, in terms of consulting many parties. The banks are in a very good position with regards to Basel III. Canadian banks have very high and strong levels of capital, which affords us the opportunity to move early in terms of adopting the new rules."
Among the big five institutions, common equity tier one ratios are undeniably solid, ranging from 9.11%, in the case of Bank of Montreal, to 11%, in the case of CIBC, at the end of July this year. ScotiaBank, Royal Bank of Canada, and Toronto Dominion Bank sit in the middle of that range.
Yet, despite their strength, the banks are not immune to international problems.
Sovereign debt worries have taken their toll. As in Europe and the US, the bond market has been characterised by volatility, going through phases of being open and closed. And those involved say it is likely to stay that way for the foreseeable future.
"We expect its going to continue to be a challenging environment, causing investors to pause and look at their portfolios" says Toronto-Dominions Walker. "The European issues will take time to work through, although we hope there will be some more near term stability."
Michael Cleary, director of DCM origination at BMO Capital Markets in Toronto, says the biggest threat to the Canadian FIG market comes from outside the country.
"The biggest risk to spreads at the moment would be at the macro level," he says. "External shocks will affect the Canadian market. The Canadian banks are well capitalised with sound risk management platforms and while there are no issues specific to Canada, if there are any other macro shocks, then Canada wont be immune."
Yet some concerns regarding the banks are more fundamental. Ratings agencies have been raising warning flags this year over household debt levels in Canada. In September, Moodys noted median non-performing loans were just 1.01% of gross lending at the end of July, a ratio it described as healthy compared to global levels. But it cautioned that rising consumer borrowing, and the threat of a possible correction in real estate prices, could push up the NPL levels. Fitch raised similar concerns in July.
"Despite record high debt-to-income ratios, persistently low interest rates have made an increased debt burden bearable by reducing households debt service ratio," Fitch said at the end of June this year. "However, there are concerns that Canadian households have become much more exposed to an adverse shock than in previous periods."
Capitalising on opportunities
Canadas financial institutions typically have limited reliance on wholesale funding, and what they do issue is diversified across products and currencies.
Some 40% of Bank of Montreals balance sheet, for example, is made up of customer deposits. Of the C$63.9bn of wholesale funding it held at the end of July, senior debt in Canadian and US dollars made up a third, in roughly equal proportions, with local currency mortgage and credit card securitisations accounting for 42% of the total.
The mix of debt types and currencies has taken the pressure off any single area as volatility has struck this year.
Nevertheless, Toronto-Dominions Walker says that, with markets remaining choppy, Canadas banks will need to take advantage of issuance windows when they present themselves.
"You need to be somewhat opportunistic, capitalising on market opportunities that are there," he says. "But, you dont want to leave too much to do in a short period of time, to then find the markets are not as receptive."
One market swing in Canadian banks favour this year has been the currency swap rates with the countrys southern neighbour. As the basis swap made funding in euros less attractive for Canadas banks, it has made the US dollar market sparkle in comparison.
"Spreads have widened recently with events going on around the world," says Walker. "Weve seen in the US market more economic pricing for us in senior for a sustained period of time. Thats unusual. Thats one of the reasons why weve been active in the US market."The effects of the basis swap can be seen in issuance levels this year. Of the $44.6bn of funding Canadian banks have taken from wholesale markets this year, almost half $20.6bn has been in US dollars, according to figures from Dealogic. That is a sharp turnaround from previous years, when issuance denominated in Canadian dollars has outstripped other currencies. In 2010, for example, of the $42bn total issued by Canadian banks, around two thirds of that was in their local currency, with just $13.7bn in US dollars, and modest amounts in euros and sterling, Dealogic data shows (see graph for more details).
A question mark still hangs over subordinated debt however. Despite their already high capital ratios, the banks are expected to look at issuing new-style hybrid instruments to fill their additional tier one and tier two capital buckets under Basel III rules which start coming into force in 2013.
Bob Nguyen in BMO Capital Markets FIG group says that a focus over the next 12 months will be finding a model of new-style hybrids that fits with the new regulatory requirements.
"We are fairly confident a market will be there for non-viability contingent capital," say Nguyen. "But it will be a joint exercise between investors, issuers and our regulator to get the right structure. The regulatory principles are just that, principles. They dont prescribe the structure. But historically, in Canada there is a high level of co-operation, and once a structure is introduced, I expect we will see harmonisation, and consistency."
|Maples return as a diversification play|
|Although Maple bonds are staging a modest return, Canadian investors are still wary of investing in international banks.
"Year to date, corporate Maple issuance is sitting at $2.8bn, which is far lower than where the market peaked before the crisis," says Michael Cleary, director of DCM origination at BMO Capital Markets in Toronto. "We would expect Maple flow this year to be in the range of $3bn-$5bn, subject to market conditions. While relative pricing has to make sense, the funding diversification that the Maple market offers is well regarded by issuers."
The market is still a long way from the issuance seen in the pre-crisis heyday. Until some stability returns, that may not change, says Peter Green, senior issuance manager in the treasury team at Lloyds Banking Group, which issued its first Maple bond last year.
"Maple bond supply has been light recently with Canadian investors less inclined to look at foreign issuers because headline risks remain high. Once we get a bit of stability we should see the Canadian dollar Maple market begin to re-open for well known credits."
Lloyds followed up last years C$350m five year issue bond, issued at 257.5bp over the Canadian sovereign curve, with a $500m issue of the same tenor in April this year at 250bp over.
The bank updates investors once or twice a year as part of its regular investor relations work.
"Weve seen benefits from our investor relations programme in Canada," adds Green. "The first Maple trade that Lloyds did was in October last year. We had over 30 investors in the book. The number of investors participating in our April trade increased by over a third. As the investor base gets familiar and comfortable with new names they become more willing to participate in trades, if the bonds are priced fairly."
Lloyds is one of the few international banks to tap the Canadian investor base this year. Goldman Sachs and Morgan Stanley have also issued. Goldman Sachs C$500m seven year was priced at 213bp over govvies, while Morgan Stanleys C$400m five year came at 230bp over.
The Maple market offers a good opportunity to diversify funding sources, says Green, although the pricing achievable is typically comparable to levels found elsewhere."The Canadian domestic investor base is very focused on global comps, with particular reference to the US market," says Green. "Canadian investors are sensitive to Canadian dollar trades not being seen as an arbitrage and they look for value in bonds that are priced fairly in the context of an issuers global credit curve. The Canadian dollar market offers issuers a good opportunity to diversify funding sources."