Royal Bank Issues NVCC-Compliant Sub-Debt

Royal Bank of Canada has announced:

an inaugural Basel III-compliant offering of $1 billion of subordinated debentures (“the Notes”) through its Canadian Medium Term Note Program.

The Notes bear interest at a fixed rate of 3.04 per cent per annum (paid semi-annually) until July 17, 2019, and at the three-month Banker’s Acceptance Rate plus 1.08 per cent thereafter until their maturity on July 17, 2024 (paid quarterly). The expected closing date is July 17, 2014 and RBC Capital Markets is acting as lead agent on the issue.

The bank may, at its option, with the prior approval of the Office of the Superintendent of Financial Institutions Canada, redeem the Notes on or after July 17, 2019 at par, in whole at any time or in part from time to time, on not less than 30 days and not more than 60 days notice to registered holders.

We routinely undertake funding transactions to maintain strong capital ratios and a cost effective capital structure. Net proceeds from this transaction will be used for general business purposes.

It’s not clear to me how the floating rate of BAs+108bp was calculated. The Canada 10-year is trading at around 2.20%, the five year around 1.55% and three-month BAs a little above 1.20%. None of these values fits very well with the 3.04% initial rate to provide a 108bp increment.

However, the important thing – for some – is the fact that a clear demarcation exists between the five-year pretend-maturity and the ten-year actual maturity. This will make it easier for the sleazy to sell the debt to the stupid.

Not much meat on those bones. The heart of the matter is the conversion feature, as noted by Moody’s:

Moody’s assigned a rating of Baa1 (hyb) to Royal Bank of Canada’s (RBC, Aa3 Negative, C+/a2 Stable) 3.04% CAD1 billion Basel III compliant NVCC subordinated debt. Proceeds from the issuance will be added to the bank’s general funds and utilized for general banking purposes. The NVCC subordinated debt provides loss absorption as it is subject to automatic conversion into common shares, based on a predetermined conversion formula, at the point of non-viability, as defined by the Office of the Superintendent of Financial Institutions Canada (OSFI), subject to regulatory discretion. This incremental loss absorption feature is credit positive for holders of senior securities of RBC, as a layer of loss absorbing securities will reduce the risk of losses incurred higher in the capital hierarchy if the bank gets into financial distress.

This marks the first issuance in Canada of contractual non-viability subordinated debt. The rating is positioned 2 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability subordinated debt. An additional notch is added relative to the notching for “plain vanilla” subordinated debt with normal loss severity (currently 1 notch below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

By way of comparison, Moody’s has the NVCC-compliant Royal Bank preferreds at Baa3:

This marks the first issuance in Canada of contractual non-viability preferred securities. The rating is positioned 4 notches below the a2 adjusted baseline credit assessment (adjusted BCA) of RBC, in line with Moody’s standard notching guidance for contractual non-viability preferred securities. An additional notch is added relative to the notching for legacy Canadian non-cumulative preferred shares (currently 3 notches below adjusted BCA) to capture the potential uncertainty related to the timing of loss absorption.

Standard and Poor’s explains what makes them more creditworthy than preferreds (bolding added):

The ‘A-‘ rating is two notches below the stand-alone credit profile (SACP), incorporating:

  • •A deduction of one notch from the SACP for subordination, reflecting our belief that the Canadian legal and regulatory framework insulates senior debt from defaults on the subordinated debt; and
  • •The deduction of an additional notch to reflect that the subordinated notes feature a mandatory contingent conversion trigger provision. Should a trigger event occur (as defined by The Office of the Superintendent of Financial Institutions’ [OSFI] guideline for Capital Adequacy Requirements, Chapter 2), each subordinated note outstanding will automatically and immediately be converted, without the holder’s consent, into a number of fully paid and freely tradable common shares of the bank, determined in accordance with a conversion formula.

The following constitute trigger events:

  • •OSFI publicly announces it has advised RBC that it believes the bank has ceased, or is about to cease, to be viable and that, after converting the preferred shares and all other contingent instruments RBC has issued, and taking into account any other relevant factors, it is reasonably likely that the bank’s viability will be restored or maintained; or
  • •The federal government or a provincial government in Canada publicly announces that RBC has accepted a capital injection, or equivalent support, from a government or agency, without which the bank would be nonviable, according to OFSI.

Because we expect this instrument’s conversion to occur at or near the point of the banks’ nonviability, we view this mechanism as a nonviability trigger.

We expect to assign “minimal” (as our criteria describe the term) equity content to these subordinated notes because we do not consider notes that have only nonviability features to be able to absorb losses prior to the bank’s point of nonviability.

By way of comparison, S&P has the NVCC-compliant preferreds at BBB+, one notch lower on the global scale than the Sub-Debts A-.

So OSFI gets a lot of discretion in determining conversion – surprise, surprise! Since bond management firms are typically much larger than preferred share management firms (I believe there’s only one of these in Canada!), and since bond investors are typically much bigger than preferred share investors (aka, “retail scum”) I believe that in a crisis there will be frenzied and successful lobbying of OSFI personnel by their future employers to convert preferreds but to ‘just wait a bit’ before forcing sub-debt conversion.

Blair Keefe, David Seville and Thomas Yeo of Tory’s Law Firm recently wrote an article titled The Preferred Share Market Finally Re-Opens For Canadian Banks:

The market is still waiting for the first offering of NVCC subordinated debt. There are a few reasons why the banks have remained hesitant to tap that market. One reason relates to changes in capital ratios mandated by Basel III, which reduce the need for subordinated debt on a bank’s balance sheet. Prior to the introduction of Basel III, subordinated debt could account for almost one-third of the total capital of a bank. With the new minimum total capital requirement of 10.5%2 (including a countercyclical capital buffer of 2.5%) of risk-weighted assets and a 8.5% minimum for tier 1 capital, effectively the most that can be satisfied with subordinated debt is 2% of the bank’s risk-weighted assets. As well, under Basel III, most deductions from capital must be made from common share equity, whereas in the past, certain deductions could be made from total capital. Effective January 1, 2015, the leverage or asset-to-capital ratio in Canada will be based on tier 1 capital as opposed to total capital. This requirement is particularly important for smaller deposit-taking institutions because they tend to be limited by their asset-to-capital multiples. As a result, we expect that subordinated debt will be eliminated from the capital structure of many smaller institutions—and will form a significantly smaller portion of the capital structure of larger institutions than it has historically.

Market uncertainty also remains over how the proposed “bail-in” debt regime will interact with NVCC instruments. In October 2011, the Financial Stability Board issued a paper providing that regulators should have the power to convert (or write off) all or part of the unsecured and uninsured creditor claims of a financial institution under resolution into equity or other ownership instruments. It was proposed that such a conversion would be done in a manner that respects the hierarchy of claims in liquidation. The 2013 Canadian federal government budget includes a proposed plan to implement a “bail-in” regime for systemically important banks3; Canadian banks and the market generally are still waiting for details as to how the federal government intends to implement this regime. The institutional investors that make up the vast majority of the market for subordinated debt are particularly concerned with how the bail-in regime will function and the effect of further dilution after NVCC instruments are converted, resulting in a “wait-and-see” approach to investor interest in NVCC subordinated debt offerings.

The precise conversion formula to be adopted by the banks for NVCC subordinated debt is not yet known. Under OSFI’s requirements, conversion formulas for both NVCC preferred shares and subordinated debt need to be set to ensure respect for the relative hierarchy of claims between the two types of instruments in the event of a triggering event. In other words, since debt ranks ahead of equity in the traditional capital structure, in the event of a triggering event, holders of subordinated debt should receive more common shares on conversion than holders of preferred shares on a dollar-for-dollar basis. The banks have put substantial effort in the development of a formula used in the preferred share offerings which addresses concerns about potential market manipulation and death spirals in situations where conversion appears to be a possibility. As of the date this article was written, all offerings of NVCC preferred shares have used the same formula based on the issue price of the preferred shares, plus declared and unpaid dividends, divided by the volume- weighted average trading price over the 10 trading days before a triggering event, subject to a $5.00 floor price. It is unlikely that other banks will depart from this formula. The preferred share formula would suggest that the conversion formula for subordinated debt will use some multiple of the principal amount of the debt, together with accrued interest, to achieve the hierarchy of claims desired by OSFI. Issuers of NVCC subordinated debt should consider obtaining an advance income tax ruling from the Canada Revenue Agency confirming the deductibility by the bank of the interest payments, although we anticipate no difficulty in banks obtaining that ruling.

So my guess is that not only will the sub-debt benefit by delayed conversion, but the floor on the conversion price to equity will be lower – say, $3-4 instead of the now-standard $5 floor for preferreds. Senior “debt”, presumably, will be lower still.

The next matter of interest is whether this non-debt gets included in the bond indices; given that they’re bank issues, and the banks own TMX, and TMX runs the standard index (this arrangement has been blessed by the regulators, in exchange for regular payments), I’d say it’s a slam-dunk. But I have no information yet.

Update, 2014-7-12: OK, so I found the term sheet on SEDAR. It’s not under Prospectus, it’s under “Marketing Materials”, dated July 9. The conversion is:

The “Contingent Conversion Formula” is (Multiplier x Note Value) ÷ Conversion Price = number of Common Shares into which each Note shall be converted.

The “Multiplier” is 1.5.

The “Note Value” of a Note is the Par Value plus accrued and unpaid interest on such Note.

The “Conversion Price” of each Note is the greater of (i) a floor price of $5, and (ii) the Current Market Price of the Common Shares. The floor price of $5 will be subject to adjustment in the event of (i) the issuance of Common Shares or securities exchangeable for or convertible into Common Shares to all holders of Common Shares as a stock dividend, (ii) the subdivision, redivision or change of the Common Shares into a greater number of Common Shares, or (iii) the reduction, combination or consolidation of the Common Shares into a lesser number of Common Shares. The adjustment shall be computed to the nearest one-tenth of one cent provided that no adjustment of the Conversion Price shall be required unless such adjustment would require an increase or decrease of at least 1% of the Conversion Price then in effect.

“Current Market Price” of the Common Shares means the volume weighted average trading price of the Common Shares on the Toronto Stock Exchange (the “TSX”), if such shares are then listed on the TSX, for the 10 consecutive trading days ending on the trading day preceding the date of the Trigger Event. If the Common Shares are not then listed on the TSX, for the purpose of the foregoing calculation reference shall be made to the principal securities exchange or market on which the Common Shares are then listed or quoted or, if no such trading prices are available, “Current Market Price” shall be the fair value of the Common Shares as reasonably determined by the board of directors of the Bank.

It’s interesting that they’re implementing this with a conversion factor, rather than changing the floor price. Just what the implications of that might be is something that will bear thinking about.

Update, 2014-7-18: DBRS rates at A(low) [Stable].

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