Nowhere is the legacy of the 2008 Financial Crisis felt so acutely than among banks globally. The near collapse of the banking system led to an overhaul of the regulatory framework governing banks, known as Basel III. International banking regulators were determined to reduce the risk of banks collapsing in the future by making them more resilient, thereby reducing the need for a government bailout in times of crisis. One result of these regulatory changes is the transfer of greater risk from governments to investors, which has created potential new opportunities for fixed-income investors.
The Cambridge team has identified some of the opportunities available within the bank fixed-income universe as a good fit for Cambridge Bond Fund. While it’s a standalone fund, it’s currently also a significant holding within the Cambridge Diversified Income and Balanced Suite of portfolios – Cambridge Asset Allocation Corporate Class, Cambridge Global High Income Fund and Cambridge Monthly Income Fund.
Public debt issued by Canadian banks
Prior to the Financial Crisis, banks funded their balance sheet primarily with a mixture of:
• bank deposits
• Guaranteed Investment Certificates (GICs)
• senior debt (deposit notes, which are traded debt and shouldn’t be confused with bank deposits)
• subordinated debt
• preferred shares
• common equity.
In simple terms, the Financial Crisis started when a select number of financial institutions could no longer make payments on their outstanding debt, resulting in bankruptcy or a bailout for these institutions. Under Basel III reforms, regulators changed the structure of debt products and the consequences for banks if they miss a debt payment. Two new structures were introduced:
1) non-viability contingent capital (NVCC) and
2) bail-in debt.
Both types of structure can be converted into common equity if a bank is at risk of defaulting on its debt obligations. Notably, this conversion would produce a material loss for the investor in these securities.
NVCC is converted in its entirety when the regulator determines the bank is approaching the point of non-viability or when a specified trigger is breached. As bail-in debt is senior to NVCC, all NVCC must be converted when or before bail-in debt is converted. Moreover, the proportion of bail-in debt to convert is determined by the regulators and doesn’t have to be converted in its entirety.
New opportunities include higher-yield instruments
In Canada, all public debt issued by Canadian banks must now be either NVCC or bail-in – a change that took effect in September 2018. There are no changes to any debt instruments outstanding before these regulations came into effect. Since this was introduced, Canadian banks have issued subordinated debt and preferred shares with NVCC provisions and issued senior debt subject to the bail-in provisions. This expands the range of outstanding Canadian bank debt instruments to include bail-in senior debt; NVCC subordinated debt; and NVCC preferred shares, in addition to the other instruments listed above.
From the perspective of a fixed-income investor, this variety of instruments adds opportunity as the newer structures have higher yields because of their additional risk, while the older, grandfathered structures are safer as they remain outstanding.
Currently, Cambridge sees the potential for attractive risk-adjusted returns from two of these instruments for material investments by Cambridge Bond Fund:
• 10-year deposit notes not subject to the bail-in provisions offer superior credit quality and, because of their longer date to maturity, will remain outstanding for a material amount of time. Prior to bail-in becoming mandatory, both Scotiabank and the Bank of Montreal issued 10-year deposit notes. These will be one of the last fixed-income instruments outstanding from Canadian banks that are not convertible into common equity. The longer date to maturity offered attractive spreads for these deposit notes while the higher credit quality helps keep spread volatility on these instruments lower.
• NVCC rate-reset preferred shares are also attractive. These preferred shares occupy the opposite end of the fixed-income risk spectrum to 10-year deposit notes. Because they are the riskiest product in the Canadian bank fixed-income universe, they offer the highest yield. It also means that they can have the highest price volatility. Since all Canadian bank fixed-income products issued going forward will potentially be convertible into common equity during times of crisis, the risk difference between these preferred shares and other fixed-income products outstanding will continue to shrink. The new debt issued will have risks that are more comparable to these preferred shares as opposed to the grandfathered fixed-income products that remain outstanding. The rate-reset feature of these preferred shares means that their coupon is reset every five years at the Government of Canada five-year sovereign yield, plus a predetermined spread. Alternatively, the issuing bank can call the shares at par. As a result, when five-year Government of Canada yields increase, the value of NVCC rate-reset preferred shares tends to increase also, which can be beneficial in a fixed-income portfolio to protect against rising rates.
Arguably, these regulatory changes have made the Canadian banking system safer for the saving public and for the government by transferring more risk to fixed-income investors. From our perspective, this greater risk has created opportunities to generate attractive risk-adjusted returns as the Cambridge team vigilantly and prudently analyzes the nuances of each instrument. Some of these opportunities will slowly disappear as legacy bank instruments mature or are redeemed. However, during the transition, we will continue to seek out these investments to enhance the risk/reward profile of Cambridge Bond Fund and other fixed-income funds that we manage
Cambridge Bond Fund currently holds approximately 16.3% of deposit notes with maturities greater than five years and 3.7% of the NVCC preferred shares as at January 31, 2019.
We appreciate your continued support.
Paul Marcogliese is a Portfolio Manager to certain Cambridge funds. He and his immediate family have an interest in the securities and funds discussed herein, but such interest is not material.”
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Published February 8, 2019