Remember those very rich bonds with 10% yields issued by several chartered banks at the height of the credit crisis in 2008-09? Sold at the customary price of $100, the bonds soared to $150 as anxiety over potential bank failures faded.
Today, however, these bonds are in trouble. Regulatory changes, known as Basel III, by the Bank for International Settlements in Basel, Switzerland, will disqualify those bonds as bank capital. Thus, they are headed for the scrap heap, and their prices are tumbling.
Known as Tier 1 third-generation issues, these bonds were issued to allow banks to absorb major loan defaults. Bonds such as Toronto-Dominion Bank’s TD Capital Trust — with a theoretical 100-year run to redemption in June 30, 2108 — had a 10% coupon with a first call in June 30, 2039. The yield was not a gift, as the bonds are deeply subordinated, extremely long-dated and have a call date that will mean more to many investors’ executors than to the bondholders themselves.
Two years ago, banks around the world were collapsing, and Canadian banks issuing Tier 1 3Gs — Bank of Montreal, Canadian Imperial Bank of Com-merce and TD (all based in Toronto) — had to offer double-digit interest rates in order to sell them. The Tier 1 3Gs, which really were intended not to exist beyond their call dates, were nicknamed “shock absorbers.” If the issuers were stressed, perhaps facing runs by frightened depositors, the bonds would turn into preferred shares with restricted holders’ right to payment.
Basel III regulatory changes will cause these bonds to have declining value as bank capital after 2013 — and no value as such after 2023. Thus, issuers will have an incentive to call them. Call dates vary from the BMO 10.221% issue due Dec. 31, 2107, callable on Dec. 31, 2018, to the previously discussed TD Capital Trust 10% issue and the CIBC 10.25% issue due June 30, 2108, callable on June 30, 2039.
Basel III’s new regulations require banks to discount these issues as qualifying Tier 1 capital by 10% a year, starting in 2013. In 2014, the bonds will have 90% of value as Tier 1 capital, then 80% in 2015, etc., until 2023, when they will cease to qualify as Tier 1 capital, and have a value at par.
The short-call bonds won’t lose all their value before call. The bonds with 2039 calls can be called at par, with the loss of all premiums over issue price.@page_break@Tier 1 capital is a measure of a bank’s strength, from a regulatory point of view. It can be in the form of common stock or non-redeemable preferreds, but the idea is that the bank does not have to pay back to anyone the amount this capital represents. The more risk a bank has in its portfolio of loans, the more Tier 1 capital it needs. If a bank holds cash or its country’s government treasury bills, then the bank need set aside no Tier 1 capital. If the bank holds unsecured bonds in its asset pool, it will need a good deal of Tier 1 capital, according to Basel III.
The Tier 1 3Gs issued in the winter of 2008 are the third generation of their species — and the ones with the longest calls. Earlier batches of Tier 1 bonds have calls well before the bonds will be disqualified as Tier 1 capital and, thus, do not share in the current discreditation problem. The Tier 1 3Gs are in the spotlight and have already been marked down to $130 on average. They may be called early, but the precise treatment of the Tier 1 3Gs rests on ambiguous wording in their covenants.
Says Brenda Lum, managing director for Canadian financial institutions at DBRS Ltd. in Toronto: “Some contain wording that allows the instrument to be redeemed at par when a regulatory event has been triggered.”
However, what defines a “regulatory event” is not clear.
The CIBC and TD bonds have provisions that allow them to be called at par if there is a “regulatory event,” says Derek Johnson, director of fixed-income with Aurion Capital Management Inc. in Toronto: “But Canada’s Office of the Superintendent of Financial Institutions has not clarified if [Basel III] is an ‘event’ or if it is just a regulatory change. The prospectus for the TD [bond] says, ‘Regulatory event means the receipt by the bank of notice or advice from [OSFI] that the [bond] no longer qualifies as eligible Tier 1 capital or [is] no longer eligible to be included as risk-based total capital.’ The words ‘notice or advice’ may need clarification when a regulatory event occurs.”
Calling bonds at par rather than at price bonuses that are usually part of the redemption schedule will make some bondholders decide never to buy the issuer’s paper again. Offending bondholders and the bond community could mean that future funding costs for the banks will rise.
“After 2023, the bonds will no longer be included in Tier 1 capital, so it’s in the banks’ interest to call them before their 2039 calls” Johnson says. “It is also in the banks’ best interests not to aggravate their bondholders. My personal feeling is that the bonds won’t be called very soon. The gradual phase-in period will allow the banks to call when rates are higher. By 2023, the bonds will be gone, but at what price is uncertain.
“The market does not think the banks will act harshly toward Tier 1 3G bondholders,” he adds, “so it is pricing in relatively early calls.”
The moral of the story is that these Tier 1 3G bonds have always had high risks. In reality, bonds that have calls before 2023 have more value than those that need not be called until 2039. May the bond investor beware. IE
“Too good to be true” bonds are just that
- By: Andrew Allentuck
- November 1, 2010 October 31, 2019
- 15:41