Page 2
Fixed Income Quarterly—Banks
Viewpoint
Canadian bank credit performed relatively in line with the FTSE TMX Corporate Canada index in the short end of the curve, but underperformed in the mid part of the curve with a 1.32% and 3.48% return, respectively, compared to the 1.39% and 3.85% return for the FTSE TMX Corporate Canada index. Overall, we are maintaining our Market Perform rating on the bank sector.
Deposit Notes – Deposit notes in the 5-year part of the curve moved in 7 bps to 77 bps in Q1/14 and are an 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 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.
extension risk is low for new style sub debt. However, if sub debt got extended, investors would receive a floating rate spread of 3M BAs+141 bps in the final five years, which is ~75 bps higher than the swapped equivalent on existing 5-year sub debt. Finally, we do not expect an NVCC sub debt deal until we get greater clarity around the bail-in regime in Canada.
Chart 2: Sub Debt vs. Deposit Note Differentials
Basis (bps) 70
60 50 40 30 20 10
0 Aug-13
US Sub Debt
2017s: BNS 2.898/17-22 Sub vs BMO 4.55%/17 Snr
43
23
12
Sep-13 Oct-13 Nov-13
2018s: BMO 6.17/18- 23 Vintage Sub vs BNS 2.242%/18 Snr
Dec-13 Jan-14
Feb-14
Mar-14
Chart 1: 5-Year Indicative Funding Costs (bps)
As at March 31, 2014
Source: BMO Capital Markets
(bps) 100
80
60
40
20
0
78
RBC Senior
70
RBC Covered Bond
66
Hydro One
50 49
Hybrids – Tier 1 hybrids have experienced significant tightening and are now trading through their Canada call. For example, the BMO 10.221%/18s are trading 21 bps through their Canada call. We do not recommend investors buy capital securities through their Canada call given the risk of early redemption. That being said, banks have not historically called capital securities early due to the P&L volatility. Furthermore, Tier 1 capital has high importance under the Basel III regime given the change in the leverage ratio.
28
Ontario AAA - PSP CMB
Chart 3: Canada Call on Tier 1 Hybrids
As at March 31, 2014
Source: BMO Capital Markets
(bps) 200
160 120 80 40 0
Current Spread
175
154
BMO - BoaTS / 31-Dec-18
Canada Call Spread
174
174
CIBC - CoaTS / 30-Jun-19
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 10–15 bps for vintage sub debt. This compares to ~40 bps for U.S. banks. The tight spread differential to senior debt is due primarily to scarcity value and the phase-out of all non-common equity capital without a NVCC clause by Q1/22. That being said, we believe the short-end (RY 4.35/15-20) provides a more attractive pick-up of 25–30 bps. We believe
169
152
TD - CaTS / 30-Jun-19
123
94
TD - CaTS / 31-Dec-18
As at March 31, 2014
Source: BMO Capital Markets