Canada's Housing Bubble

Dec 20, 2010 Chris Fournier bloomberg.com

The bonds of Canada’s financial firms underperformed their American counterparts this year, giving up ground made in 2008 and 2009, amid a U.S. expansion drive and concern that household debt in Canada is rising.

The Bank of America Merrill Lynch Canadian Financial Index, which tracks 246 bonds with a par value of C$151 billion ($151 billion), is up 5.3 percent this year. That’s less than the 8.2 percent gain by U.S. banks and insurers.

The nation’s banks, voted the world’s soundest for three straight years by the World Economic Forum, are adding risk as they expand in the U.S. Bank of Montreal made its biggest acquisition ever last week to add a Wisconsin lender. In addition, rising Canadian household debt, which tops U.S. levels, may jeopardize earnings, Moody’s Investors Service.

“A good question bond holders need to ask themselves is, what happens if the Canadian consumer is overstretched and you had a real downturn in the Canadian economy how would that play out?” Peter Nerby, senior vice president in the financial institutions group at Moody’s, said by phone from New York. “That could affect the earnings streams from those core Canadian businesses.”

Moody’s put Bank of Montreal on review for possible downgrade after it agreed on Dec. 17 to buy Milwaukee-based Marshall & Ilsley Corp. for about $4.1 billion.

‘Transformative Acquisition’

Bank of Montreal, the country’s fourth-largest lender, agreed to pay 0.1257 of its own stock for each share of Marshall & Ilsley to expand its Chicago-based Harris Bank. BMO’s U.S. operations have “underperformed and not been consistently profitable in recent years,” Moody’s said in a research note.

“This is arguably a transformative acquisition, certainly transformative within their U.S. operations,” Nerby said. “Transformative acquisitions can be very attractive to shareholders. They’re also the kind of transactions that can expose bondholders to risk.”

Elsewhere in credit markets, Canadian Imperial Bank of Commerce suggested the Bank of Canada may want to intervene to weaken the Canadian dollar; economists in separate surveys predicted that inflation slowed in November, and retail sales rose in October for a fifth month; and Canada’s budget deficit widened as corporate and sales taxes dwindled.

The extra yield investors demand to own the debt of Canadian investment-grade corporations rather than the federal government held steady on Dec. 17 at 142 basis points, or 1.42 percentage points, from 142 the week before, according to a Bank of America Merrill Lynch index. Yields dropped to 3.94 percent, from 4.07 percent.

Provincial Bond Market

The securities fell 0.2 percent this month, paring the gain this year to 6.7 percent, compared with advances of 7.9 percent for U.S. corporates and 6.2 percent for global company debt.

In the provincial bond market, relative yields narrowed to 53 basis points on Dec. 17, from 54 on Dec. 10. Yields sank to 3.21 percent, from 3.35 percent the week before. The securities are down 5.7 percent this month.

Consumer prices rose at an annual pace of 2.2 percent last month, Statistics Canada is likely to say tomorrow in Ottawa, according to the median of 17 economists’ forecasts in a Bloomberg survey. The pace was 2.4 percent in October.

Retail sales rose 0.5 percent in October, after rising 0.6 percent the month before, according to the median of 16 economists forecasts compiled by Bloomberg. Sales haven’t declined since May. The nation’s statistics agency will report the data tomorrow.

Intervention Suggestion

Bank of Canada Governor Mark Carney may want to consider selling Canadian dollars as an option to temper gains in the currency driven by purchases by other central banks, Avery Shenfeld, chief economist at CIBC, wrote in a report Dec. 17.

The loonie’s strength undermines Carney’s ability to raise interest rates to slow increasing household debt levels, Shenfeld said in the report. Further gains in the currency may slow growth, he said.

“There is one weapon yet to be touched: fighting fire with fire,” Shenfeld wrote . “Canada could match foreign central- bank intervention in favor of our currency with an offsetting intervention, selling an equivalent volume of loonies.”

Canada’s currency fell 0.8 percent to C$1.0140 versus the U.S. dollar on Dec. 17. It rose to parity with its U.S. counterpart in September 2007 for the first time in three decades, riding a boom in commodity prices.

Household Debt

Canada’s ratio of household debt to disposable income was 1.48 in the third quarter, according to Statistics Canada, exceeding the U.S. level for the first time in 12 years. Bank of Canada Governor Mark Carney, Finance Minister Jim Flaherty and Prime Minister Stephen Harper said in separate appearances last week they’re concerned about rising debt and the risks that poses to the nation’s economic recovery.

“The U.S. has gone through some painful deleveraging, at great pain to the banks,” Moody’s Nerby said. “It’s a reasonable question to ask how the Canadian banks will perform if that happens.”

Bank of America Merrill Lynch’s U.S. Financial Corporates Index, comprising 1180 bonds with $1.15 trillion outstanding, lost 10 percent in 2008, as relative yields, or spreads, exploded to 768 basis points a month after the bankruptcy of Lehman Brothers Holdings Inc. in September 2008. The index rebounded in 2009, returning 19 percent. After peaking at 881 basis points in March 2009, spreads shrank to 186 in April.

Canadian financial bonds returned 0.3 percent in 2008 and 15.5 percent the following year. Spreads tightened to 123 basis points by the end of 2009, within 0.1 percentage point of longer-term averages.

‘Very Comfortable’

“People are still very comfortable with the credit profile of the Canadian banks, but they made up a lot of ground last year,” Altaf Nanji, senior credit strategist at Royal Bank of Canada’s RBC Capital Markets unit, said by phone from Toronto. “There wasn’t as much to make up this year, whereas for the U.S. banks, coming out of the downturn in the credit cycle, we’ve only now started to see the banks gain any traction.”

U.S. financial bond yields traded within 72 basis points of their Canadian counterparts on Dec. 15, the tightest since April 23, according to the Bank of America Merrill Lynch data.

“The Canadian banks trade at much higher price-to-book multiples, their credit spreads are much tighter,” Nerby said. “If you were tight, or rich relative to other banks, you can get cheaper. If banks that had difficulty got very, very oversold, maybe they’re getting richer.”

Among the six largest Canadian lenders, the bonds of Bank of Montreal, Toronto-Dominion Bank have performed worst this month, with declines of 0.6 percent each, Bank of America Merrill Lynch data through Dec. 16 showed.

TD Expansion

Toronto-Dominion, the country’s second-biggest lender, may reach an agreement to buy Chrysler Financial Corp., the auto- loan company owned by Cerberus Capital Management LP, three people with knowledge of the matter said this month.

Royal Bank, Bank of Nova Scotia and Canadian Imperial Bank of Commerce have performed better, losing 0.3 percent each. CIBC and National Bank of Canada are down 0.5 percent.

Moody’s downgraded Royal Bank’s credit rating last week for the first time in at least 15 years to Aa1 because of the lender’s increased focus on investment banking and trading.

Canadian financial bonds are lagging behind Canada’s broader corporate market, which is up 6.7 percent this year, Merrill data show.

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