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Harry Koza's column

Harry Koza,
Friday, April 27, 2007,
Spring Fashions


"It will make or break him so he's got to buy the best,
cause he's a dedicated follower of fashion." - The Kinks
, 1965 
We don't have spring fashions in the bond market.  It's pretty much a belt-and-suspenders kind of world - any colour you want, as long as it's grey.  Novelty for novelty's sake is not welcome.  Variety may be the spice of life, but in the bond market, it just makes us reach for the Maalox.
The stock market is always looking for the next big thing, the latest new idea for beating the index.  This season, their hot fashion is the LBO, which hasn't been this trendy since the ?80s.  It's like painter's pants or platform shoes making a comeback.
Still, from time to time, the bond market does come up with something new, though it's more like buying a new tie to go with the grey pinstripes than getting a makeover and a whole new wardrobe
Sure enough, in the past week, there've been a couple of new wrinkles on the bond theme that look sure to become the hot trends this year.
The first one comes from the recent angst in the corporate bond world over the LBO phenomenon, which has roiled credit spreads and generally fostered a newly exquisite sensitivity to the credit risks associated with companies being acquired by highly-leveraged new owners.
Brookfield Asset Management last week brought to market a new issue of ten year bonds with a feature that institutional investors went gaga over. In the event of a change of control and a cut in ratings below investment grade, investors can put the bonds back to the company at 101 cents on the dollar, plus accrued interest.
If some private equity outfit wants to take a run at Brookfield, bond holders can relax and say, "Bring it on, dudes - make my day."  After being sandbagged recently by Sallie Mae and Bell, bond investors are really liking this feature a lot, and it seems sure to become virtually mandatory for corporate issuers from here on out. 
The other cool new idea hit the runway on a deal this week from RBC Subordinated Notes Trust.  OSFI (Office of the Superintendent of Financial Institutions) has newly revised some of its regulations for bank capital, including one that now allows subordinated debt issued by non-consolidated financing entities (NCFE's) to qualify as Tier 2B capital for banks.
Now, let's not get too far into the arcane and Byzantine byways of bank capital rules.  Suffice to say that banks have several kinds of regulatory capital: deposit notes, low Tier 2 debt, Tier 2B, Tier 2A and Tier 1, and there are various esoteric definitions of what qualifies for each of those and different limits and ratios governing the amounts of each, with varying tax ramifications for each category. I won't delve too deep into this as it would bore us both silly and would fill several columns besides.
The thing is that by issuing subordinated notes through a non-consolidated financing entity like RBC Subordinated Notes Trust, the Royal Bank can raise capital while simultaneously avoiding the need to pay pernicious capital taxes.
Capital taxes being possibly the most wrong-headed, productivity-sapping, job-destroying, regressive form of taxation in this overtaxed dominion of ours, it was only a matter of time before someone figured out a way to avoid paying them.  Sure, Jim Flaherty, like his predecessors as Finance Minister, admits that capital taxes are ineffective, inefficient and regressive, and - also like his predecessors - is determined to eliminate them (on some suitably geological timescale, of course).    
Anyway, by not having to pay all that capital tax, RBC Sub-notes Trust's deal was able to add a small price concession to its new issue, so that it yielded a few basis points more than regular Royal Bank subordinated debt. It's fully guaranteed by the parent bank, so buyers of the paper get the same credit exposure with a little extra yield.  While a few investors might have liked to see a bigger chunk of the tax savings passed on in the form of an even bigger yield concession, few of them were willing to pass up a good deal, so they were all over this one like ants at a picnic.  A billion dollars worth sold in a New York minute and there were orders for twice that amount. Launched on Monday at +44.9 beeps over 5-year Canadas, by the day's close the issue was quoted at +43 to +42 over.
This idea has legs. I called up Zaheer Khan, a former bond rater now vice-president of corporate investments at Baker Gilmore Associates in Montreal, my go-to guy when I have questions about stuff like trust indentures, bank capital requirements and other esoteric minutiae of the credit market.
I asked him how much room the big banks have for more of this kind of Tier 2B sub-debt.  "Plenty," he said, proceeding to list, off the top of his head, the various ratios of the different capital tiers for the big banks and how much leeway they had to issue each kind. Basically, there's room for billions more. 
So, depending on their capital ratios and how much room they have for the various tiers, all the well-dressed banks will likely be wearing NCFE Tier 2B sub-debt this year. 

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