By Wesley Blight, CFA, CIM, FCSI
Portfolio Manager, Fixed Income
Did you all catch the big news headlines roughly two weeks ago when Canada’s big six banks had their credit ratings downgraded by Moody’s?
According to Moody’s, the downgrade reflects its “ongoing concerns” about how the “continued growth in Canadian consumer debt and elevated housing prices leaves consumers, and Canadian banks, more vulnerable to downside risks facing the Canadian economy than in the past.”
Banks are critically important to the Canadian economy, as well as Canadian investors, so when you see huge headlines about the banks’ credit ratings being downgraded, how worried should you be?
Moody’s concerns are nothing new
When a bond’s rating is downgraded, the rating agency is telling investors that there is an increased chance that the bond will not meet its payment obligations. As a result, the bond’s price should fall to reflect the increased uncertainty, but only if the supporting rationale for the downgrade is considered new information. Often, the price declines before the rating is updated.
When Moody’s downgraded Canada’s big banks, I asked myself whether there was any new information that I wasn’t aware of. The idea that our team might have missed vital new information is the sort of thing that keeps me up at night.
But, after some research and discussion with my team, I concluded that wasn’t the case. Even though each of the banks’ ratings had been downgraded by one notch, they all maintain a rating of A1 or higher and are considered to have a low to very low credit risk.
And honestly, it sounded like Moody’s was recycling from their January 2013 report, where they wrote about their “ongoing concerns that Canadian banks’ exposure to the increasingly indebted Canadian consumer and elevated housing prices leaves [the banks] more vulnerable to unpredictable downside risks facing the Canadian economy than in the past.”
How credit ratings affect bond prices
Because Moody’s rationale for downgrading Canada’s big banks was based on widely known information, the bond prices of each bank experienced very little change. But had this rating action truly reflected a material change in the banks’ risk profiles, prices could have moved significantly.
So let’s take a step back and see how bonds and credit ratings work.
When you buy a bond, you’re lending money—whether it’s to a government (federal, provincial or municipal) or a corporation. And when you lend money, you want to know how likely you are to get it back.
A credit rating can help an investor determine that probability. Bond issues with a higher rating (i.e., AAA) have a higher probability of being repaid, whereas lower credit quality issues are considered less likely to meet their obligations.
Bonds are rated by credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch—who together represent about 95% of the global market. In Canada, the Dominion Bond Rating Service (DBRS) has a significant share.
The rating (or grade) from these credit rating agencies can have a material impact on bond prices. If a bond gets a high rating, and investors are certain about getting their money back, the interest rate would be lower. With lower rated bonds, investors who accept a higher probability of not getting repaid deserve higher compensation in return.
In downgrading the big banks’ credit ratings, Moody’s suggested that their bonds are now riskier. But judging from the market’s reaction, that wasn’t the case. Because the rating action wasn’t based on any material new information, the banks’ bond yields barely rose (and their bond prices barely fell).
For the banks’ deposit notes, the average price change around the time of the announcement was less than $0.05 on a $100 investment. Their price has since partially recovered and, in my view, the price change was more likely attributable to external factors that were unrelated to Moody’s decision.
Why the big banks are worth owning
From my perspective, the information from credit rating agencies can be valuable. But when selecting bonds for our funds, including those of the banks, ratings are no substitute for thorough, independent credit analysis.
And in my opinion, Canadian bank bonds remain part of a sound investment strategy because they are heavily regulated and maintain ample capital and liquidity on their balance sheets. They have also been actively diversifying their business segments for lower exposure to domestic retail banking. I am confident that the banks will continue meet their bond payment obligations and that our investments will earn their expected compensation without undue risks.
Though a downturn in the housing market would have a direct impact on the banks’ mortgage loans, prospective credit losses are limited by Canada’s well-structured mortgage market. And, more importantly, total loan losses for banks would have to more than double the experience in the global financial crisis before eroding their tangible common equity (i.e., their ability to pay the bills).
In our MD portfolios, we have meaningful exposure to both bank bonds and stocks. As examples, 15% of the MD Short-Term Bond Fund and 22.5% of the MDPIM Dividend Pool are invested in Canadian banks.
Bonds: With respect to our bond positioning, which is held across all MD funds and pools, we have a higher allocation to senior bank debt compared to lower rated bank debt (i.e., subordinate paper).
Senior bank debt offers more income than government bonds. They also provide better liquidity compared to subordinate paper and can be bought or sold quickly without large changes in price.
I value this exposure because it provides additional income while retaining strong downside protection; however, I am always seeking to add value and, if there was an opportunity to add subordinate paper at a discount to fair value, our current exposure is appropriately positioned to take advantage.
Stocks: In our stock portfolios, we have maintained a consistent heavy positioning in big banks despite the downgrade.
While there are ongoing concerns about the housing market and other factors such as the credit risk in the energy sector, I believe these risks are reasonable when you weigh them against the potential rewards.
The relationship between risk and reward is dynamic and forever changing. Sometimes it’s captured by the credit rating agencies, and sometimes it’s not. It is our independent credit analysis that allows for timely decision making and the ability to take advantage of all investment opportunities.
On the whole, I think the risk relative to the reward for the bank stocks remains very attractive. However if the risk/return profile does change, we will make the necessary adjustments to ensure that our funds and pools are appropriately positioned to meet their objectives.