Fixed Income Quarterly—Banks
Page 3
From a fundamental perspective, TD is one of our preferred credits due to its defensive business mix, solid Canadian fran- chise, 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.
Key Themes
NVCC – After three long years, the non-viability contingent capital (NVCC) market became reality in Canada in 2014 with RBC, NA, CWB and LB issuing four preferred share deals totalling nearly $1.1 billion. The deals went very well as exhibited by the strong demand from investors. For a more detailed look at the NVCC structure, please see our comment titled, “NVCC Becomes Viable in Canada” published on February 10, 2014.
Overall, we are not surprised by the issuance of NVCC given the high amount of non-common equity capital redemptions expected over the next few years. Furthermore, OSFI an- nounced in early January that it intends to replace the current Assets-to-Capital multiple (ACM) test with the Basel III Tier 1 leverage ratio in January 2015 compared to January 2018.
Chart 4: Remaining Capital Phase-Out Schedule (C$ Equivalent – Billion)
important banks to hold a higher loss absorbency require- ment similar to what is being considered in Europe and by U.S. regulators (e.g., 17–20% of risk-weighted assets). Finally, banks could look to issue sub debt to create a larger buffer for senior debt holders, which will help reduce the higher senior funding costs expected under bail-in.
Assuming banks hold a Tier 1 leverage ratio of 3.5%, we estimate the NVCC sub debt market could be as high as ~$23 billion. Not surprisingly, this is significantly lower than the ~$31 billion of Tier 2 capital that is currently outstanding. It should be noted that the size of the NVCC sub debt market is highly sensitive to the buffer that banks hold on the Tier 1 leverage ratio. For example, if banks hold a leverage ratio of 4% the need for sub debt decreases to $6 billion.
Table 1: Potential Size of the NVCC Sub Debt Market
As at January 31, 2014 Source: BMO Capital Markets
How Much Will NVCC Sub Debt Cost? – On March 10, 2014, Australia and New Zealand Banking Group Ltd. (ANZ) issued a US$800 million 10-year bullet Basel III NVCC sub debt at 180 bps back of U.S. Treasuries. We estimate the NVCC premium was ~30 bps relative to non-NVCC subordinated debt.
Table 2: ANZ NVCC Pricing
As at March 12, 2014 announcement date Source: Bloomberg
Overall, we were surprised the NVCC premium for the ANZ deal was so tight at ~30 bps, particularly given the deal was sold to institutional investors and not retail investors. We believe the features of the ANZ NVCC subordinated debt deal are less in- vestor friendly and more complex compared to the RBC NVCC preferred share deal issued in January. For example, the floor price was 20% of the share price at time of issue compared to
Basel III Leverage
BMO
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BNS
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CM
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NA
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RY
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TD
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Total
27,776 23,138 13,923
6,152 2,315 615
3.25%
3.50%
3.75% 4.00% 4.25% 4.50%
4,802 4,802 4,802 4,014 2,315
615
6,042 6,042 3,933 1,577
0 0
2,625 1,214 6,835 6,259 1,422 661 4,636 5,576 219 108 1,793 3,069 0 0 0 561 0 0 0 0 0 0 0 0
$12.4
Tier 1 Tier 2
$7.0
$7.6 $7.6
$9.5
$6.4
$3.8
$2.3
$5.5
$3.4 $2.3
$5.6
$2.7 $1.0
$1.4
$2.4
$4.1
$3.9
$3.0
$2.3
$2.1
$1.7
$1.4
$1.4
$1.0
2014 2015 2016 2017 2018 2019 2020 2021 2022
ANZ NVCC Subordinated Debt
USD
10-year US Treasury 2.7% Indicative Non-NVCC Sub Debt 1.5%
NVCC Premium 0.3%
Cost of ANZ NVCC Sub Debt
4.5%
Note: Based on BMO Capital Markets assumption of capital redemptions As at March 31, 2014
Source: Company Reports, Bloomberg, BMO Capital Markets
What About NVCC Sub Debt? – Sub debt is expected to have reduced importance under the Basel III regime compared to Basel II due to the focus on Common Equity Tier 1 capital (CET 1). In addition, the early implementation of the Basel III Tier 1 leverage ratio is expected to reduce the need for sub debt in the future.
That being said, we believe sub debt will likely still have a role under the Basel III regime. First, the Canadian banks may need to issue sub debt to manage their total capital ratio. Second, the bail-in rules in Canada could require domestic systemically