Fixed Income Viewpoint
Banks – April 2014
Sector Rating: Market Perform Relative Value
5-Year: Market Perform 10-Year: Market Perform 30-Year: Not Rated
Risks
M&A – We do not expect any transformational acquisi- tions; however, we could see some tuck-in acquisitions in Wealth.
Trading Liquidity – Banks are on average the most liquid.
Regulatory – We believe bail-
in debt will likely be imple-
mented on a statutory versus
contractual basis and will
only apply to new issuance
after a certain date. Overall,
we believe bail-in will: (1)
increase the cost of funding
for banks; (2) put pressure
on senior debt ratings to reflect lower uplift for government support; and (3) increase the use of secured funding such as covered bonds or NHA MBS.
New Issuance – The big 6 Canadian banks issued C$21.2 bil- lion of wholesale funding across all currencies in YTD 2014 (deals greater than two years and greater than C$100 million) compared to C$23.0 billion in the year-ago period. That being said, deposit note issuance in the domestic market has declined ~34% to $8.5 billion in YTD 2014 compared to $12.9 billion in YTD 2013 given attractive funding alternatives outside of Canada, particularly covered bonds in Europe.
Credit Profile
Sector Financials – The big 6 Canadian banks reported cash operating earnings of $8.0 billion in Q1/14, up 7% Y/Y. The strong performance in the quarter was due primarily to solid Canadian P&C earnings, strong contribution from Wealth Management, better-than-expected trading revenues, high securities gains and lower loan loss provisions.
Sector Fundamentals – Credit fundamentals remain strong for the Canadian banks. Capital ratios exceed the minimum Basel III requirements with an average CET 1 ratio of 9.3%. In addition, we estimate the Canadian banks already meet the more onerous Basel III Tier 1 leverage ratio of 3%. Finally, we believe the risk of a housing correction is manageable due to the high percentage of the mortgage portfolio that is insured and the low LTV on the uninsured book.
Credit Ratings – On February 6, 2014, S&P published a Request for Comment (RFC) on the proposed changes to the criteria for rating bank hybrid instruments. Under the proposed cri- teria, all Tier 1 instruments could be downgraded one notch to reflect the risk of partial or untimely payment if the capital buffers were breached.
Spread View – Deposit Notes – Deposit notes in the 5-year part of thecurvemovedin7bpsto77bpsinQ1/14andareinan impressive 25 bps from our recommendation back in September 2013. We believe the tightening in deposit note spreads is due to the general tightening in corporate credit spreads over the past six months and the expectation for existing deposit notes to be grandfathered under the bail-in regime in Canada. Overall, we believe there remains some additional room for spreads to tighten if existing deposit notes are grandfathered; however, we believe the magnitude of the spread tightening will be more modest over the near term given the bail-in will not likely be implemented before 2015 and the banks are expected to be active in the wholesale term funding markets. Furthermore, we do not believe deposit notes should trade through covered bonds, which are currently at 70 bps in the 5-year part of the curve. Subordinated Debt – We believe the spread differential between sub debt and deposit notes is tight at 15–20 bps for new-style sub debt and 10–12 bps for vintage sub debt. This compares to ~40 bps for U.S. banks. The tight spread differ- ential to senior debt is due primarily to scarcity value and the phase-out of all non-common equity capital without a non- viability contingent capital (NVCC) clause by Q1/22. That being said, the short end provides a more attractive pick-up of 25–30 bps. Hybrids – Tier 1 hybrids have experienced sig- nificant tightening and are now trading through their Canada call. The CIBC CoaTS 19s continue to offer an attractive ~20 bps pick-up relative to other bank hybrids.
Credit Curve – We believe the 2016 part of the deposit note curve looks attractive given the steep roll down.
Sector Value – We believe sub debt looks expensive relative to deposit notes. For example, the spread differential between BMO 6.17%/18-23 (sub debt) and BNS 2.242/18 (deposit notes) is back to pre-crisis levels of only 12 bps. Canadian bank sub debt also looks expensive relative to U.S. bank sub debt, which typically trades ~40 bps back of senior debt.
Recommendation
Top Pick – TD is one of our preferred credits from a funda- mental perspective due to its defensive business mix, solid Canadian franchise, and strong risk management and capital ratios (Basel III CET 1 ratio of 8.9%). TD Bank is also less dependent on wholesale funding compared to its peers due to its strong deposit base.
George Lazarevski, CFA
BMO Nesbitt Burns Inc. george.lazarevski@bmo.com (416) 359-7488