ANNOUNCER: TD Asset Management welcomes you to this week's podcast. As a reminder, this podcast cannot be distributed without the prior written consent of TD Asset Management.
NAOUM TABET: We all know that central banks globally have been increasing interest rates essentially to reduce inflation expectations. But when short term interest rates are higher than long term interest rates, we get a situation that we're in today. And what's interesting is that today, money market mutual funds are one of the highest yielding asset classes. Well, that's an opportunity as well as an issue, because banks experienced deposit outflows to those mutual funds.
But banks really got into trouble or some banks, some can hear U.S. regional banks, some European banks. And that trouble came from being concentrated at deposit base. Also, some liability mismatch. Well, what I mean by control deposit base means that, for example, Silicon Valley Bank (SVB) had a couple of deposits and a few large tech companies. And when those two companies got into trouble, well, you know what? Deposits started to come out. And second - a concentrated deposit base could be that you have a few very large depositors. And if a small portion of them leave, well, you're not left with much. Well, second is the liability mismatch. Well, to simply put it, when you deposit money at the bank, the bank turns around and invest that money in deposits, generally in bonds.
So, when they invest that money in bonds, while interest rates go up - bond prices decline. And if bond prices decline, then the value of what's left in capital is lower than the value of the deposits owed. Well, these really caused a bit of a snowball effect because headlines were out on many social media and media outlets and caused some of the regional banks to get into trouble.
Well, this podcast is not about the bank's financial troubles or SVB. Many people wrote about that and spoke about it. Today we'll focus on the investment opportunities in bank issued debt and how those opportunities really came about. With me today is ANTHONY FOSS, he's a 22-year asset manager and veteran focused on the financial sector and credit analysis.
So, he is the person we want on our side, when there are stresses and opportunities that appear in the banking sector. My name is NAOUM TABET, and I lead the institutional Client portfolio management team at TDAM, and I'll be your host today.
Anthony, why are Canadian banks in a better financial position than some of the global counterparts?
ANTHONY FOSS: Yeah. Okay. Well, that's a great question. I'd like to say, first of all, thanks for having me on. It's a really interesting time to be a credit analyst, especially one who covers banks. So, it's been a busy time here. What's different here? Well, just to set the backdrop, as you talked about what's going on down in the States, you know, these are not asset problems.
These are not bad assets. Like, remember the tech bubble and the Great Financial Crisis. Like, those are bad assets, bad tech assets, bad mortgage assets. This is a liquidity problem. And as you describe, there's problems at some banks that are very idiosyncratic. And those problems, though, I think the Fed Reserve has come out and the regulator in Europe has come out and they have stepped up and take major actions to try to stem that contagion that was starting to be like a stack of dominoes moving through the banks.
And so, I think they've done a pretty good job of that. And if you look at the deposit flows now, you know, it has really, kind of, stemmed the flow of what was happening there. There's still a bit of outflow in the U.S. banks and Canadian banks because of people getting out of low yielding deposits and getting into money market funds and other places.
But really that contagion is taken care of. So, for Canada, we don't expect - we're not expecting that to happen here. We do have an insured deposits for sure - our level is even lower than the states, at $100,000. But, you know, the banking system is really concentrated. In the U.S. you have thousands of these small regional banks.
We don't have that here. You don't have people trying to get out of these little banks getting into safer, bigger banks. They're already in the big safe banks. We don't expect that to happen here. And the Canadian banks, they're highly regulated, They're large, well-diversified. And if you do look at the problem areas that have crept up in the states like unrealized losses on debt securities, you know, those are very, very small in terms of the Canadian capital.
And we don't think they're ever going to have to realize those losses because they have so many different liquidity options. Deposits flowing out doesn't force them to have to go and sell assets to fill that gap. Not to mention the Bank of Canada has a liquidity facility to backstop the whole system. We you're not going to see the same kind of problems here.
You know, the other thing we looked at was office real estate - if you stress test that, we just don't see big problems for the Canadian banks. And remember, before all this started, we had very strong capitalized banks after the Great Financial Crisis, the regulator came out: You got to more quality, more quantity in your capital and we've got that.
And the banks have taken very strong loan loss reserves relative to their losses. So, you know, I think the Canadian banking system is in a better financial position for sure, than a lot of other banks out there.
NAOUM TABET: Awesome. So maybe when we think about the Canadian banks and you've mentioned that the Canadian banks are in a better position now. So maybe add to it that there is not a lot of banks in Canada that the regulator is more involved. But the Canadian banks- the depositors are more concentrated in those big six banks.
What I want to ask, though, is: it's true that the Canadian banks are not at risk, but they're not completely immune from the situation in a way say that it's because the financial sector in Canada, internationally, all of it experienced material declines in equity prices. Also, we experienced credit spreads widening in the financial sector. Obviously, this is because market participants started pricing in that risk of global financial contagion, which you said that it doesn't seem like to be a major risk, but that really created excessive fear, which really drove investors to flee the sector in a panic and led to certain securities becoming unnecessarily oversold.
And I'm getting into the meat of the conversation here. That security that has been oversold- called a capital security, some people mistakenly call it an NVCC, non-viable contingent capital. They're actually capital securities. They're issued by bank. And like I was saying, they're quite attractively priced today. Before we get into it, I have a couple of questions for you, Anthony, because these are complex securities.
First, if you think about those complex securities, how are they structured? What are they? How do they work? Can you please give us an overview of that?
Let's just back up a little bit here. So, you know, the banks got a ledger - on one side of that ledger, they have assets. On the other side, they have liabilities. So what does that mean? Assets: That's loans. They're making loans to people. But in order to make those loans to people, they have to find all of that cash has to come from different fundings sources.
And they have a range of different funding securities that they can use. That's basically a stack. And that stack has high yielding, higher risk common equity all the way up to very low yielding, low risk deposits or covered bonds. The bank is funding itself with all of that cash that it brings in. And those and it's using a range of different securities.
From an investors perspective, there's a huge different range of opportunities in risk and return in the middle of that range of securities are the are the capital securities. They don't have the highest yield, but they're also not the riskiest as well. This current system really came out of the Great Financial Crisis where they said no more bail-outs, no more government having to put money into banks that got into trouble.
Let's do bail-ins. And so, these capital securities were designed in a way to absorb losses in the event that a bank gets into a problem. So today we're talking about debt securities like alternative tier one, also known as LRCN or Limited Recourse Capital Notes or Tier two sub debt, also known as NVCC or “Non-Viability Contingent Capital.”
These securities have got to follow a priority of claims, so each successively higher piece of funding in that stack gets paid more in the event that there's a problem at the bank. So, per thousand dollars of a tier two security that you own, you would get more equity than you would get if you owned an alternative tier one security in the event that we had to convert everybody over to equity in part of a bail-in.
Also, everyone gets more than the equity holder because of all this new equity that's getting created - dilutes the equity holders. But it's important to remember these differences that I'm talking about throughout this stack of securities, really only comes into play if a bank gets into trouble. We don't expect that currently for the Canadian banks because of all the reasons we've already talked about.
NAOUM TABET: Anthony, when you when you say about “conversion to equity,” it was recently in the news with Credit Suisse who really was forced by the regulator to write off some of those capital securities or LRCNs and investors lost all their investment capital ... is that risk that exists within Canadian bank issued capital securities?
ANTHONY FOSS: Without getting into all the gory details, is it safe to say, I think that what happened in Switzerland was a little bit of a unique and different situation from Canada. With Credit Suisse, the regulator managed to write off some of these AT1 capital securities. It was all part of a way to make the deal with UBS come together and they were able to do that without doing a full resolution of Credit Suisse.
You end up with a bit of a strange situation where the AT1 holders or the capital security holders got wiped out while the equity holders in that situation held on some value. The priority of claims that we talked about was not maintained, but that can't happen in Canada. As I've explained our system, in Canada, you will always get more in the stack than the person below you in that stack.
So, the priority of claims has to be maintained and our regulator came out and reminded us about that just a little while ago after the Credit Suisse event took place. Secondly, in Canada, as I mentioned, if a bank gets into trouble, capital securities get converted into equity, they don't get wiped out. That is written in the contracts. So, there's no possible way that that would happen.
And thirdly, as I mentioned, you know, we just think of a non-viability event happening in Canada is very low. We don't expect losses to occur in these capital securities.
NAOUM TABET: So maybe just quickly summarize from my perspective and from most investors' perspective, there's no free lunch - in investing in capital securities, you're really getting compensated for a few risks and thinking about those capital securities, those risks are, the trigger of a conversion. Or there's also something that we didn't touch about - extension risk because those capital securities could be called at a specific date or could be extended.
So, talk in first about that conversion issue. You clearly noted that, you know, that's not an issue. Canada is well structured from a regulatory perspective. And banks are well structured from an asset liability standpoint to have multiple sources of revenue. There's not a lot of deposit flows. Risk number one is really behind us. I just want to touch on risk number two, which is extension risk. And what does that mean? The bank could basically defer prepayment due to certain market conditions. What I mean by that, each one of those capital securities has a call date and basically, it's date at which the bank can just pay back principal or it could say, you know what, I'm going to extend and I'm not going to trigger my call and I'm going to extend it to the next call date.
But today, I think this risk is on the higher side because interest rates and credit spreads, they've increased over the last year. We all know that. And the incentive to call is lower because, you know, the bank that issued a debt at a much lower rate- they're not going to want to call and then reissue that same amount of debt at a much higher yield.
So, there is some extension risk here. But we believe that from a portfolio management standpoint that banks are incentivized to call those securities because they feel that it's a great source of funding. And if they don't call them, then maybe there's not going to be a lot of demand for those securities as they come to market again with them.
So, I want to talk about that loss absorption mechanism that you touched on, just using the actual term that is most used that risk is behind us. The extension risk is there, but there is an opportunity that we could take advantage of where we're at - those issuing banks might not extend. So, if you think about Canadian capital securities from an attractiveness standpoint, the yields have increased from an average of 4% to about 8% on average in the last six months. So that's a very attractive yield for Canadian bank issued debt. And we believe that those securities are oversold, and they do provide a tactical opportunity to institutional investors. I just want to highlight that we currently hold these securities in our active fixed income strategies, and we are technically adding to the position. I want to conclude by saying that the recent financial stresses really highlighted that there are some vulnerabilities in the banking sector.
Canadian banks clearly more conservative, well managed in their global counterparts, and that we continue to affirm that capital securities could be an attractive opportunity for a diversified institutional portfolio, provided obviously that investors understand and are willing to accept the associated risks. There's a lot more to talk about this subject, and if you need more information, please reach out to your relationship manager.
Thank you. And thank you very much, Anthony!
ANTHONY FOSS: Thanks for having me.
ANNOUNCER: The information contained herein has been provided by TD Asset Management and is for information purposes only. The information has been drawn from sources believed to be reliable. The information does not provide financial legal tax or investment advice, particular investment tax or trading strategies should be evaluated relative to each individual's objectives and risk tolerance. Certain statements in this podcast may contain forward looking statements that are predictive in nature and may include words such as expects, anticipates, intends, believes, estimates and similar forward-looking expressions or negative versions thereof.
Forward looking statements are based on current expectations and projections about future general economic, political, and relevant market factors such as interest and foreign exchange rates, equity and capital markets. The general business environment. Assuming no changes to tax or other laws or government regulation or catastrophic events, expectations and projections about future events are inherently subject to risks and uncertainties which may be unforeseeable.
Such expectations and projections may be incorrect in the future. Forward looking statements are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any forward looking statement. A number of important factors, including those factors set out above, can contribute to these digressions. You should avoid placing any reliance on forward looking statements TD Asset management Inc is a wholly owned subsidiary of the Toronto-Dominion Bank. TD Asset Management operates through the TD Asset Management Inc in Canada and through Epoch Investment Partners Inc in the United States. TD Greystone Asset Management represents Greystone Investment Bank, a wholly owned subsidiary of Greystone Capital Management, all of these affiliate and wholly owned subsidiary of the Toronto Dominion Bank.
