HEIGHTENED RECESSION RISKS
The Canadian economy is beginning to show strain from the 475 basis points of cumulative interest rate hikes enacted by the Bank of Canada (BoC) since March 2022. Key data demonstrates a widespread slowing of economic activity: the unemployment rate has increased to 5.7% from its trough level of 5.0% this year, and real GDP growth is decelerating. The trend of these economic data points compels us to emphasize caution and prioritize the resilience of our portfolios by preparing for the materialization of recession risks. If we look to the past as our guide, one area of the market that saw outsized hardship was the financial sector during the global financial crisis (GFC) of 2007-2009. It is important to understand how this sector has changed since the GFC to understand what risks we may be exposed to today if we see a hard landing unfold.
BASEL III REFORMS AND CAPITAL REQUIREMENTS
Basel III refers to a set of bank regulations that were enacted in response to the GFC by the Basel Committee, which oversees global banking standards. These regulations brought forward many changes for banks with the intent of bolstering their ability to weather economic and sector-specific uncertainties. One of the most notable changes was the standard level of loss-absorbing capital each bank is required to have, with higher levels of capital required according to the risk profile of the financial institution, as well as its importance to the global and domestic financial systems.
The Office of the Superintendent of Financial Institutions (OSFI) is the regulator for Canadian banks. It has the authority to control the domestic stability buffer (DSB), which is an additional capital requirement (within CET1, further discussed below) for domestically significant banks in times of mounting economic risks. The purpose is for banks to build up capital when times are good so that they can absorb losses during hard times. This buffer was most recently increased from 3 to 3.5% in response to rising risks in the banking sector. This announcement increased the required capital levels for all domestic systemically important banks (D-SIB) in Canada, which include Bank of Montreal, Bank of Nova Scotia, Canadian Imperial Bank of Commerce, National Bank of Canada, Royal Bank of Canada and Toronto-Dominion Bank.
With the establishment of stricter and more well-defined capital requirements came the emergence of financial instruments that make up each level of this capital structure. Each level of the capital structure serves a different purpose in absorbing bank losses. The chart below provides a simplified overview of these layers.
Source: QV Investors, OSFI, BMO Capital Markets
The most junior tier and first to absorb losses is Common Equity Tier 1 (CET1), or common shareholders. If OSFI deems the bank non-viable, the next two levels of the capital ladder, Tier 1 and Tier 2, will be converted to equity to absorb losses. If this is insufficient to absorb the totality of bank losses, bail-in debt will then be used as a last resort. This structure is designed to be self-collapsing, meaning if a Canadian bank were to fail, which we see as a low probability event, the securities it has issued will absorb the losses, avoiding the need for government support and effectively shifting the risk onto investors instead of taxpayers. In order to attract investors to take on this risk, securities lower down in the capital structure offer the potential for higher returns. From a bond investor’s point of view, it is important to keep this balance of risk and reward in mind when deciding what tier of the capital ladder we are comfortable investing in at different points of the cycle.
OUR FIXED INCOME TEAM’S PROCESS
Since the GFC, banks have taken measures to reduce internal risks and attract investment while satisfying regulators. However, we must acknowledge that tail risks still exist. The lower that we venture down the capital hierarchy, the more we expose ourselves to risks. This isn’t to say that we should avoid these securities at all costs, but rather it emphasizes the importance of building ourselves a margin of safety. We achieve this by investing when valuations adequately compensate us for taking on these additional risks. In times of increased economic uncertainty, we can also build a margin of safety by choosing investments in the more senior layers of the bank capital structure, where there remains less risk of being converted to equity. Our bond strategy currently holds senior bail-in bonds, as we believe we are being compensated for the risks associated with these investments.
Although a Canadian D-SIB failure remains a low probability, during past risk-off events, market valuations have gotten carried away to reflect a higher failure probability. By understanding the details of these securities, we can act when valuations diverge from fundamentals, and have the conviction to zig when the market is zagging.