Friday, January 30, 2009

Desjardins calms a spooked bond market

By Andrew Willis in the Globe & Mail Streetwise:

To the applause of fixed income investors, Desjardins Group showed Thursday that a controversial financing decision by Deutsche Bank last month did not set a nasty precedent for bond markets.

Desjardins Capital, an arm of the Quebec financial services conglomerate, did exactly what companies are supposed to do Thursday with $450-million of bonds that didn't come due until 2014, but featured an call option that kicked in this month.

Why does this matter? Glad you asked. One way banks finance their operations is by issuing what's known as fixed-floating rate debt. The convention in the market – and it's only a tradition – is that the debt is retired, or called, when the fixed-rate period expires. That's typically half way through the life of a 10-year bond. Investors then turn around and buy new fixed-rate debt.

The credit crunch sent interest rates soaring and made it attractive for companies to break with tradition, and opt to flip into floating rate debt for the next five years.

And that's just what Deutsche Bank did last month with a 1-billion Euro bond issue. Investors freaked when this happened. The spread between fixed-floating bonds and comparable government bonds rocketed upwards, as investors priced in risks that they previously had not taken seriously. All of this put a spotlight on the Canadian banks, which have been active players in this corner of the debt market, and are creeping up on the deadlines for calling bonds.

Desjardins was the first to hit such a deadline, and it demonstrated Thursday that other issuers will follow unwritten market rules. As a result, the premium paid to issue this debt dropped across the board. (In bond market terms, the spread tightened on all fixed-floating offerings.) In plain english, Deutsche bank made it more expensive to run a bank, Desjardins just made it cheaper.

“Most investors believe that Canadian banks will not extend the maturity on their issues due to significant reputational risk and to higher future costs if they want to maintain access to this funding market,” said a note Friday from TD Waterhouse. The next Canadian instutition to hit a deadline on calling bonds will be Royal Bank of Canada.

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