Facing a political stalemate in the United States that has the potential to cause upheaval in global financial markets, Canadian banks are stockpiling cash.
In the course of just eight days, four of Canada's largest banks have tapped investors for almost $6-billion in new debt. That total is about three times as much as the Big Six would typically raise in one month, highlighting their desire to raise money at a time when borrowing is cheap and foreign investors crave Canadian-dollar investments.
Financial markets have been on edge all week as Republicans and Democrats in the U.S. wrangle over raising the country's debt limit. U.S. Treasury Secretary Timothy Geithner has warned that if the limit is not raised by Aug. 2, the government would not have enough money to meet its obligations. But so far the two main parties have not been able to strike a deal, causing equity markets to wobble and the U.S. dollar to decline.
Investors have been seeking safer havens amid the turmoil, including gold, the Swiss franc and the Canadian dollar. That is making it cheaper for Canadian banks to borrow, as investors are willing to pour money into the biggest financial institutions, even though these firms could take a major hit if a debt crisis breaks out.
Toronto-Dominion Bank's latest $1.75-billion debt deal on Wednesday tied Royal Bank of Canada's record for the largest domestic bank financing. And it wasn't the only deal investors bought: Earlier in the day, Bank of Montreal raised $1.3-billion that was quickly scooped up by investors.
The banks are more than happy to take the funds. Bond yields have plummeted since peaking in April, sending the five-year government yield down to 2.15 per cent from 2.9 per cent. Assuming no changes to the banks' funding spreads over government bonds, that plunge would save TD $13-million a year in annual interest costs on its $1.75-billion issue. Over the five-year life of the new deposit notes, that equates to $65-million in savings.
"As things get dicey, [the banks]tend to take the money when it's cheap," said credit research analyst Altaf Nanji at RBC Dominion Securities.
To prove this theory, Mr. Nanji and his colleagues looked back at the months with the highest levels of bank debt issuance in Canada and found they were all when the markets were in turmoil. In September and October of 2007 when fixed-income markets were in disarray, Canadian banks raised $5-billion and $6-billion in new debt, respectively. The same level was reached March, 2008, when Bear Stearns was on the verge of bankruptcy.
Today, with the threat of a U.S. default looming, the banks are raising money again because the consensus in the financial sector is that their funding costs would jump higher if a deal to raise the debt ceiling is not reached.
There is also the possibility that an unknown negative event could spread fear throughout the market, forcing the banks to conserve capital and stop lending to each other. Were that to happen, the sudden lack of liquidity would be reminiscent of when credit markets froze in the fall of 2008.
Despite this nightmare scenario, few people expect it to happen.
"I have the same view that many others would, which is this will get resolved, saner heads will prevail. And I think the market has already seen through to the other side when this will cure itself," said Tim Hockey, head of Canadian banking and insurance at TD. "It's an interesting political theatre, but I think it will resolve itself."
Still, some say it is surprising that investors are willing to lend the banks money at such low yields. Even though the threat of credit markets freezing up is minimal, even the slightest risks are typically priced into bond yields. The higher the risk, the higher the yield investors require.
Yet Mr. Nanji believes that investors aren't concerned about the risk right now because they're just happy to get their hands on new bank debt. Financial institutions are typically serial borrowers, so they comprise the biggest chunk of most fixed-income investors' portfolios. Before the recent flurry of deals, the banks had not issued any debt since March and investors were desperate to get their hands on new bonds with different maturities.
In fact, all Canadian corporate debt issuance had ground to a halt in late June and early July, creating a 32-day drought during which not a single company raised money. After such a long dry spell, investors have cash to burn.