CAPITAL
TD Securities assesses shifts in industry activity and executes well-defined financing strategies on behalf of clients. Our expertise in identifying market trends and strategic opportunities has distinguished us as leaders in the marketplace.
| MARKET DEVELOPMENTS |
| The Value of Credit Derivatives |
Credit Derivatives are a relatively new type of financial instrument that, for the first time, allow the credit portion of a bond or a loan to be traded separately from its other terms.
This relatively simple concept of being able to "trade" credit risk in the same way that other risks (i.e. interest rate risk or currency risk) are traded has revolutionized the market for bank loans and corporate bonds. The ability to go "short" a credit (or to go "long" a credit that isn't traded in the capital markets) has spurred the development of a whole range of risk management and credit pricing techniques.
Investors who were once unable to access the credit markets are now able to trade them synthetically using credit derivatives. Credit investors, such as banks, are able to manage credit on a portfolio basis, rather than as a collection of single exposures. And borrowers and issuers of securities are also getting access to a much larger pool of capital.
TD Securities was ideally positioned to develop leadership in the credit trading business given that the lending operations of TD Bank and the significant trading operations of TD Securities created natural "long" positions that provided incentives to trade or "sell" credit positions to others. The result is more opportunity and flexibility for our clients. A few examples of how clients have used credit derivatives follow.
MANAGING CREDIT EXPOSURE
A client of TD Securities, a major European bank, wanted credit exposure to a particular Canadian corporation. The only available opportunity was an outstanding 12-year bond, but the European client had only ten-year lines of credit available for that potential exposure.
TD Securities offered the bond with an option to "put" the bonds back to TD Securities at the end of ten years. The option was a so-called "default contingent" option - meaning that if the borrower were to default during the ten-year period, the client's option would no longer be valid. In effect, the client was taking ten-year credit risk to the issuer of the bond at an acceptable return, something the bank client would not have been able to achieve otherwise.
BUYING AND SELLING CREDIT CAPACITY
A Canadian insurance company wanted to gain exposure to the US syndicated loan market but did not have the infrastructure to administer loans or monitor covenants. A US bank, a client of TD Securities, wanted to reduce its credit exposure to one of their important borrowing clients.
Credit protection was bought from the Canadian insurance company and sold to the US bank. The relationship was unchanged between the US bank and its client in administering the loan and monitoring the covenants. But credit lines were freed up, giving the bank the ability to do further credit business with its client. The transaction was structured so that, similar to a bond, the insurance company received a fixed payment every six months. They would only have to make a principal payment if there was a default on the loan. The fact that the insurance company's credit exposure is "off balance sheet" offered them an additional advantage.
ACCESSING CREDIT MARKETS
A large European corporate borrower had need for a sizeable amount of Euro currency. Because the company had been a frequent borrower in Europe, TD Securities believed the demand for their debt would be stronger in North America. The borrower could have issued US$ denominated paper and then hedged the risk with a cross-currency swap, but was concerned about possible accounting changes that might require that the swap be "marked-to-market" on their books. In addition, TD Securities felt that the combination of the loan and the cross-currency swap would be more expensive than a Euro borrowing and a derivative trade. A syndicate led by TD Bank in London structured a term loan in Euros. A North American investor sold credit protection to the European lenders via TD Securities in return for a US$ fixed semi-annual payment.
Credit risk was thus transferred from Europe to North America, and a cheaper cost of borrowing was achieved for the borrower.
Credit derivatives are the fastest growing segment of the overall derivatives market. The British Bankers' Association estimates that the total market grew from US$180 billion in 1997 to US$350 billion in 1998 and is forecast to reach US$740 billion by the end of 2000.
| WHAT IS A CREDIT DERIVATIVE? |
| A credit derivative, like any other derivative, is a contract where the value of that contract is derived from another instrument. Bank loans, bonds, leases or any other instruments or agreements that are the obligation of a borrower are all credit products. Credit derivatives are instruments, or contracts, that are structured and trade in relation to those credit products. |
| TD Securities Inc. is a member of the ISDA working committee that develops credit derivative documentation, and is a member of the Eurex Working Committee for Exchange Credit Derivatives which has developed, in conjunction with a leading software company, the first "off the shelf" credit pricing and risk management credit software package for client use. |
| Increasing Use of Preferred Shares |
In 1999, TD Securities was very active in the introduction of preferred securities, a significant instrument new to the Canadian equity market, and one which provided our clients with opportunities to raise capital in a tax efficient manner.
BENEFITS OF PREFERRED SECURITIES
Several factors have been driving the preferred equity market: low interest rates, stable credit markets and the relatively large capital needs of corporate issuers.
What makes both the traditional and new preferred instruments attractive to investors is the typically higher yield they provide compared to conventional fixed income securities such as bonds and GICs. Stable, and relatively low, interest rates prompted individual investors to purchase preferred equity in near record amounts in 1999. While the payments from preferred securities are taxable as income, the new preferred securities result in long-term junior capital with tax deductible dividends.
Only seasoned and top-quality issuers have been able to take advantage of this new instrument. While investors are prepared to accept the typically very long maturity (up to 49 years) and the junior security ranking of the securities, they will only do so from those issuers who they believe will be around for the long term and who are capable of maintaining the quarterly payments.
Alberta Energy Company Ltd., Canadian Pacific Ltd., Enbridge Inc., Magna International Inc., Suncor Energy Inc., and TransAlta Corporation were among the issuers who took advantage of this new market. Over $1 billion in Canada was raised in these long-term preferred securities in 1999.
The traditional preferred market was also very strong during the year. Nearly $2.8 billion was raised by 13 issuers, including Bell Canada, The Toronto-Dominion Bank, Westcoast Energy Inc., Enbridge Consumers Gas and Nova Scotia Power Inc. TD Securities acted as lead underwriter for each of these five companies, as co-lead underwriter for Power Corporation of Canada, and as underwriter in eight other offerings.
"1999 was an extraordinary year for the preferred market," says TD Securities' Denys Calvin, who is responsible for TD Securities' preferred equity business. "We expect the pace of innovation to continue in 2000 as a number of new issuers, particularly financial institutions, emerge. However, we expect the retail investor to be a little less enthusiastic in 2000 given concern over rising interest rates. We may see some caution as a result of pressure on utility common stock prices, which was the case when TransCanada PipeLines Ltd. decided to lower its common dividend last December.
Both traditional preferred shares and the new preferred securities will nevertheless remain a significant part of the Canadian capital markets, and TD Securities is well positioned to maintain its leadership."
| WHAT ARE PREFERRED SECURITIES? |
| Preferred securities are like traditional preferred shares in that they rank below debt in priority of claim. But from a tax standpoint, they perform more like a debt instrument. Payments are treated as interest in that they are fully taxable to the investor and tax deductible to the issuer. |