Spreads narrow for NVCC bonds on FTSE inclusion

Managers move to snap up lower-rated debt

The consultation process is over and now it’s time for implementation.

That’s the state of play for Canada’s fixed-income managers given that FTSE Russell, the index provider against which their performance is measured, has determined which bonds will and won’t be included in the indexes.

In this case, we are referring to $15.8 billion of nonviable contingent capital issued by Canadian banks prior to July 2017, which will now be included in the FTSE Russell indexes in early February, with Feb. 7 being the most likely date.

Specifically, according to a memo recently circulated by FTSE Russell, NVCC bonds issued before July 1, 2017, “will be eligible for the FTSE TMX Canada Universe Bond Index.” In addition (according to an FTSE mid-2017 decision), newly issued NVCC bonds will also be eligible for inclusion. The memo added one proviso: “all other index eligibility criteria” have to be met.

FTSE Russell made this decision, according to the memo, based on “careful consideration of the feedback received as part of this consultation, and in support of the objective of the benchmark to provide an accurate representation of the domestic Canadian investmentgrade fixed-income universe.”

As part of that consultation, the respondents were given three options re inclusion: excluding the debt issued before July 2017, phasing it in over a pre-determined time period, or including it.

FTSE Russell’s decision to include such debt in the index is significant because fixed-income managers will now, most likely, have to buy them. Prior to the recent news, they didn’t have to because they were not in the index. In general, the NVCC bonds, which were rated a couple of notches below the bank’s normal credit rating, provided some extra yield — and hence some outperformance for managers.

Since the FTSE Russell news was conveyed to the market, bond managers report there’s been some activity. “The spreads have narrowed,” said one, indicating that managers aren’t waiting until Feb. 7 to make their moves.

The $15.8 billion to be included in the index comes from four of the Big Six banks: only Bank of Nova Scotia and National Bank didn’t issue such debt, which was allowed to count as Tier 2 capital following the global financial crisis.

The four banks started issuing the sub-debt in the summer of 2014 with Royal Bank leading the charge with a $1.5-billion financing. In all there were 15 issues that typically provided investors with five years of fixed interest and then five years of variable interest. The expectation was the debt would be called after five years because the floating interest would be too expensive.

The regulators, both global and local, made that decision as part of a plan to ensure investors — and not just taxpayers — took some pain in the event the issuing bank encountered severe financial problems. The regulators determined, if a so-called triggering event occurred — in effect the institution became non-viable — the sub-debt would convert to equity according to the formula. They would receive 1.5 times their original investment in common shares. In this way, the debt-holders would become equity investors.

The situation changed last summer when the federal government released a plan on “bail-in” legislation laying out how banks will be funded. As part of that plan, the term Total Loss Absorbing Capacity (TLAC) became part of the lexicon.