Financial firms’ bond yields “exceptional”

Although there are risks in holding long-term subordinated debt that deserve compensation, this spread over federal government debt — twice the usual 100 bps — is exceptional. Moreover, this corporate bond’s return is comparable to a generous stock dividend yield — with a lot less risk.

Pessimists view the European sovereign-debt risk problem as the tipping point for global banks and insurance companies. Their view is that Greece will not have an orderly restructuring but will officially default, forcing banks holding Greece’s sovereign bonds to write off those losses against earnings and cut assets by calling in loans — especially those to other banks.

In this view, Euro-pean banks will rush to New York-based banks for infusions of cash, leading to falling prices for bank-issued bonds and stocks as institutions infected with Greece’s bonds recapitalize. And Canadian banks won’t be immune from this impending global banking crash, these pessimists say.

But that’s far too dour a view, argues Walter Schroeder, chairman of Toronto-based DBRS Ltd. Schroeder says that what happens in New York often stays in New York: “Housing in Canada never collapsed, as it did in the U.S.; Canadian mortgage borrowers have not walked away from their homes, for the strategic reason that their loans exceed their net worth in their homes.

“[Canadian banks] are less leveraged,” he adds. “Our lending standards are more conservative than those in Europe and the U.S. We did not have a subprime mortgage crisis; we did not have a collapse of commercial mortgage-backed securities; and our system, with lower leverage and lending ratios, is just not as fragile as the U.S. or European banking systems.”

A U.S.-based bank’s name on a bond is taken as a negative these days. But not all such bonds are equally challenged, says Vivek Verma, vice president of Canso Investment Counsel Ltd. in Richmond Hill, Ont. For example, a Merrill Lynch Canada 5% issue due Feb. 18, 2014, has recently been priced to yield 4.7% to maturity.

This bond, issued in Canadian dollars, has no currency risk and pays 360 bps more than a Government of Canada issue of similar term. The Merrill Lynch issue is a senior bond from the Canadian entity and guaranteed by Merrill Lynch & Co. Inc. in the U.S., which is a subsidiary of Bank of America Corp.

“As we see it,” Verma says, “the bond is strong on its own merits, strong in its issuer’s capital structure and backed by a global giant.”

It is a matter of judging the risks. For example, a Manulife 5.16% issue June 26, 2015, has recently been priced to yield 3.43% to maturity — 220 bps over a Government of Canada bond of similar term. Manulife, like other Canadian lifecos, is suffering on its income statement because it’s getting less interest income from its own investments. In theory, that means less coverage for the bonds Manulife has issued — and that’s the market’s conclusion.

“The market assumes that the low rates that have hurt Manulife’s earnings are here to stay,” Verma says. “But we think that rates have to rise, and that Manulife will make more money. These are senior bonds from the biggest lifeco in Canada and not subject to being extended, as bank subordinated debt may be.”

At the centre of the storm, bank bonds remain a buying opportunity, says Edward Jong, vice president and head of fixed-income with TriDelta Financial Partners Inc. in Toronto: “Most of the bank capital trusts, which are vehicles for their subordinated debt, are rated single-A by the [credit-rating] agencies and are paying what amounts to BBB yields at 180 to 220 bps over Government of Canada bonds. Even senior debt, the banks’ deposit notes, are at 128 bps over Canadas.”

This is significant, Jong notes, because the normal spread for senior bank debt is usually 40 to 60 bps over federal debt.

So, what should you advise your clients to do? If you think that the bond market has overreacted to the perils faced by Canadian banks, you should recommend your clients capture the generous spreads for the bonds of Canadian financial services institutions.

“The level of concern in markets,” says Chris Kresic, co-head of fixed-income and a partner with Jarislowsky Fraser Ltd. in Toronto, “is exaggerated.” IE