September 9, 2016 / 5:06 PM / a year ago

TD Bank reopens US callable Tier 2 market with blowout deal

NEW YORK, Sept 9 (IFR) - Toronto-Dominion Bank found overwhelming demand from global investors for a US$1.5bn callable Tier 2 bond this week, buoying hopes the US dollar market will open up to more banks looking to cut the cost of complying with capital regulations.

The deal was the first of its kind with a call feature sold into the US since 2013.

Banks issuing into the US have traditionally stuck to bullet deals instead, mainly because investors are sceptical of the incentive to call and so charge banks more for the option, bankers said.

But investors appear to be getting more comfortable with the structure - believing that TD has a strong incentive to retire the debt after 10 years - while a broad-based hunt for yield has also helped boost demand for riskier securities.

“We have heard for the longest time that the US market is a bullet-only market, but people are getting more comfortable now with valuing the call option,” one financial institutions analyst told IFR.

A banker on the deal said it would not have been possible to sell the callable issue into the US market without the tremendous rally in credit markets over recent months.

The need to find bigger returns is pushing investors into riskier subordinated debt, even if there is only a sliver of extra spread, the banker said.

“We needed that kind of backdrop so investors would be more open-minded about fair value on a callable trade.”

While there is a risk to investors that TD does not call the bond after 10 years, the bank does have a strong incentive to do so.

That is mostly because the capital benefits of the debt start to diminish in the final years before maturity, losing 20% of Tier 2 capital treatment per annum in the final five years of a bond’s life under Basel III regulations.

The 10-year call feature gives TD the option to retire the debt early - saving five years of paying interest on the debt even as its regulatory benefit declines.

Interest costs may also become more expensive if TD does not call the bond at the first - and only - opportunity on September 15, 2026. The coupon resets after that point to 220.5bp over the prevailing five-year mid-swaps rate.

The coupon on the bond currently is 3.625%.

PRICING THE OPTION

Instead of issuing a 15NC10 deal, TD could also have sold a 10-year bullet structure. But a 10-year would have had a lower capital benefit, and only would have cost a fraction less.

Investors across Asia, Europe and the US poured US$10.5bn of orders into the trade, enabling TD to squeeze pricing to just 5bp wider than where it would have priced a 10-year bullet trade.

The deal priced at T+205bp, the tight end of guidance and well inside IPTs of T+237.5bp.

While the majority of buyers were happy to stay in the deal even after guidance was released 22.5bp-32.5bp inside IPTs, around US$1bn of orders were pulled at that point.

“This basically got priced as a 10-year with a little bit of spread for the optionality,” said one investor who dropped out of the book, saying he was not being paid enough for the extension risk.

“It’s priced and structured to be called, but the world could be very different in 10 years, and we want more of a give for that optionality.”

Market participants were stunned by how tight the deal priced, but said it was unsurprising given the strength of global demand in the book.

The bonds were trading around 9bp tighter on Friday morning.

Deutsche Bank was the last issuer to sell a callable Tier 2 bond into the US, in 2013. However, that transaction performed poorly in the secondary market - and the structure failed to catch on among US investors.

“The US market never really believed in the moral obligation to call,” said a DCM banker away from TD’s deal.

“TD is the right name to enter the market with this structure. It’s rated Single-A, which is helpful for a lot of investors that would otherwise have walked away from it.”

TD Securities, Goldman Sachs, JP Morgan and Wells Fargo were bookrunners on the transaction. (Reporting by Will Caiger-Smith; Editing by Natalie Harrison and Shankar Ramakrishnan)

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