Thursday, September 27, 2007

Banks Sell Medium Term Debt at Premium Yields

Financial Post, Sean Silcoff, 27 September 2007

Faced with dwindling demand for their short-term debt offerings, Canadian banks have lured investors in the past month by selling massive amounts of medium-term debt securities at bargain prices.

The biggest issuer so far has been Royal Bank of Canada, which has sold $4.4-billion worth of three-to-five-year senior deposit notes in five separate offerings since mid-August, an amount and volume of deals market observers characterized as unusually high.

RBC typically raises such funds outside Canada, but "we tapped the Canadian market this time around because it was the most attractive source of funding," said Katherine Gay, a spokeswoman for the bank's RBC Capital Markets division.

"We're very active in the Canadian debt markets now because it's the most effective source of funding for us and the fact we're getting very strong investor support for the RBC name. We simply did the math, and it's the right thing to do."

But bond investors doing the math have come to their own conclusions: The price for such high-quality debt is a steal. RBC's debt has been sold at spreads as much as 93 basis points (93/100ths of 1%) above comparable government of Canada bonds. Those spreads are double or more what such securities yielded in June, offering a significant premium for bond investors accustomed to earning 5% to 6% per year.

"When you look at where spreads have traded, it's kind of a gift," said Marc-Andre Gaudreau, vice-president of corporate bonds with Mont-real-based Natcan Investment Management, which manages $16-billion in fixed-income assets. "It tells me that the banks from a historical standpoint are cheap relative to the rest of the market. To me it's just a sign investor appetite is not as high as it was before."

Bank of Montreal also last week sold $800-million worth of 10-year subordinated notes at 135 basis points above Canadian bonds. That spread was about 70 three months ago.

Mr. Gaudreau said he expected more large debt offerings from Canadian banks before their fiscal years end next month.

The well-priced issues of high-end bank paper have sold quickly as shrewd bond investors -- who are typically happy to beat the returns of their peers by 2/10th of 1% -- pounce on opportunities created by the global credit crunch.

"This is a very unusual circumstance and an extremely attractive one as long as you do the work to make sure securities you are buying are high quality," said Scott Lamont, head of fixed-income at Phillips, Hager & North, a Vancouver-based fund manager with $45-billion in fixed-income assets. "These are the kinds of opportunities we wait for as active managers."

But Mr. Lamont said he didn't expect the good deals to last for much longer. The banks "have concluded in the last two weeks they can sell as much as they want at [higher yields]," he said. "But they've probably concluded they don't want to continue to have to pay these kinds of yields to attract investment dollars. Rather than issue at those spreads, they'll [keep assets] on their balance sheet. Either spreads will come down or they'll issue less of it."

Some seasoned bond investors speculate the large debt offerings are part of an effort by the banks to free up their balance sheets so they can "repatriate" assets such as car and mortgage payments that were previously rolled into short-term securities called "asset backed commercial paper. " The ABCP was typically rolled from one 30-to 90-day issue into the next. But because of a meltdown in one part of the ABCP market in August, investor appetite for all such securities has dropped in Canada -- even the offerings sponsored by the banks. "It's part of a flight to quality," said Mr. Lamont. "A lot of people will go to the most risk-averse alternatives," such as government bonds.

As a result, banks are expected to wind down these instruments and take the assets back on to their books. This could increase their cost of capital and weigh on their returns, as ABCP has become a convenient way for banks to turn assets into tradeable securities they sell to investors, allowing them to deploy capital more effectively.

"Now they will have to hold them on their balance sheet, and have more assets to fund than they planned to" said Mr. Gaudreau.