Differential

Differential can mean many different ( no pun intended ) things. Car guys in the group finally think I am writing something for them. While I hate to burst anyone’s bubble, this is not about diff’s on a car. Oddly enough, diff rhymes with Tiff, but I digress..

Today I want to look at how yields can effect and change a lot more than just the 5 year rate offered by a bank or monoline lender ,and how it can easily become a vicious cycle. Today, I am going to pick on TD Bank – not because I hate them, or think they are inferior, but because I think they are a great example of what has been happening and what may be to come.

As of Sunday June 9 the Canadian 5 year bond yield was 3.497%, while the US 5 year Treasury yield was 4.461. That is a difference of 96.4 bps, but I am gonna round and say 100, because I really don’t want to type 96.4 out several times. For a refresher course, lets remember what all of this means: If you invested $100.00 into Canada 5 year government bonds, you would be paid $3.50 per year in interest. 5 years go by, and you get your $100.00 bond principle back to do what you want with. Now, this is where the financial planners go ape shit and tell me that is not true, because you buy the bond today for over $100.00, but let’s remember I am trying to keep things simple.

Now, being a Canadian investor, you could also decide to purchase a US Treasury bond for $100.00 USD, and get a return of $4.46 USD a year. 5 years goes by, and you get back your USD $100.00. Now you are presented with a problem, a bit of a quandary you might say. Would you rather collect $3.49 Canadian a year in interest, or would you rather collect $4.46 a year USD in interest ( about $6.00 CAD in todays exchange environment ). Now of course, you would have to spend about $135.00 CAD to receive the $100.00 bond, so let’s keep that in mind. Now it starts to get a little spicy.

The great thing about money, is that money is not emotional – it simply flows to wherever it can generate the highest return for its owner. Now, to decide whether we want to buy the Canadian or US bond, we have to do a little sleuthing and investigation. We have to do our best to figure out the risk / reward trade off. So, let’s take a little look. Now, both the US and Canadian governments are spending like drunken sailors on shore leave. So that is basically the same risk. Both bonds are considered the ‘ risk free rate ‘ in their respective country, so that nets us back out to zero. So, we have to start looking at something to do with the currency. Where do you see the Canadian and US currency going over 5 years? Popular consensus ( doesn’t mean it is right ) says the USD will continue to strengthen on the CAD / the CAD will get weaker on against the USD / a combination of the two.

So, if you spent $135.00 for the $100.00 USD bond today, and this scenario came true, you might be in a situation where in 5 years the USD / CAD is $1.50. So, your $100.00 USD that you paid $135.00 for, is now suddenly worth $150.00. Also, the interest you received every year is now worth more in Canadian dollars when you convert it. Now, the opposite is also true, whereby you could get less. However, this is where risk / reward comes in. If you had to bet, which economy and currency do you think outperforms in the next 5 years? Most people will have the same answer.

Now, back to TD Bank. TD Bank is a multinational bank – not just a Canadian Bank. In fact, TD has more retail branches in the US than they do in Canada. In Central Florida, I have 4 TD branches within a 5 miles drive of my house. Now let’s say that TD had a little excess cash laying around – because let’s face it, they are a bank, and banks make gobs of money. If TD was going to invest that cash, where would they invest it? Would they invest in Canada at a return of 3.497%, or would they invest in the US at a rate of 4.461%? Would they invest in USD which is widely expected to appreciate, or in CAD which is widely expected to depreciate? Would they invest in a country where the top tax rate is between 21% and 39% ( depending on State), or would they invest in a Country where the top tax bracket is 53+%?. All of these factors start to come into play. The return you get on the government bond, the currency, and the tax rate all play a part.

Now, the lower the spread of differential is on the bonds, the less of a problem this presents to investors and corporations. At some point if the spread is too small, it isn’t even worth paying the bean counters to figure it out. As of Oct 31, 2023, TD Bank had a little over 406 Billion dollars of short term cash on hand. The 96.4 bp interest rate differential on 406 billion dollars adds up to a lot – about 3.9 BILLION in excess earned interest. Now of course TD would not take every dollar and invest it in government bonds, but you get my drift here.

We are now getting into a point though where it isn’t just big banks that can make a lot of ‘ free ‘ money on interest rate spreads. As spreads start to widen out, it makes a lot more sense for smaller and smaller companies to invest in US bonds over Canadian bonds. And by smaller companies, I don’t mean mom and pop pizza shops, but small, big businesses. On top of that, companies will potentially start to shift funds out of CAD and into USD to take advantage of these spreads. Most of the large companies in Canada have parent companies in the US. If you were Wal Mart or Amazon, or Netflix, or Spotify, or Apple, or Google, would you be investing the proceeds from Canadian operations in Canada bonds at 3.49%, or move them back home and invest them at 4.46%? As this starts to happen , it also creates sellers of CAD currency, to convert back into USD currency, which could start to weaken the CAD even further, which makes our currency scenario more advantageous to our investor above. Round and round we go. The cycle begins.

Getting back to TD for a moment, as we all should know, TD is a large investor for monoline lenders. TD provides a good chunk of conventional money to monoline lenders. Now, if TD decided to invest their capital in the US, rather than in Canada, what does that do for available capital for conventional uninsurable deals? Lets run a little comparison for a moment. Let’s say TD provided some funds for a conventional mortgage at a rate of, oh lets say 5.40%. Now, TD could have also invested that money in a US Treasury bill for 5 years, and received 4.46%. Lets strip out currency exchange, taxation, projections, assumptions, and everything else. Lets also assume TD had no costs to fund the mortgage – which we all know they do, but let’s ignore that. Is funding that mortgage worth a 90 bps premium? Is 90 bps worth the risk of loaning money on a Canadian mortgage? Quite possibly it is. Personally for me it is not, but I am not TD bank. However, if yields start to rise in the US, and the differential gets smaller and smaller and smaller, why would TD Bank risk the mortgage, when they can invest risk free with the US Government? Simple answer – they won’t. They will allocate a lot more of their funds to a risk free rate in the US if the differential gets too small. This will make getting a conventional mortgage a lot harder – especially in the broker channel.

Money always must compete with other forms of investment – both in Canada and abroad. Every investment is constantly measured on a risk return platform, but also on a reward vs. the competitors platform. Of course no investor would put all of their ‘ eggs in one basket ‘ but they could easily start allocating away from Canadian mortgages which are starting to become risky. Why would you take the risk in a mortgage if you could invest in government bonds for almost the same return? Simple answer – you wouldn’t. While it is important to watch the Canadian bond yields, also don’t forget to look South every now and then and see what is going on. The impacts of that may affect your mortgage business more than you know.

Now we all know that TD is not the only large bank with US operations. The mortgage brokers latest love – BMO is also gobbling up US assets at a torrid pace. Ironically enough, every week I get a flyer from BMO and a flyer from TD with an offer to open a bank account and receive my free toaster – it is America after all. RBC while pulling back immensly on US operations, still does have interest in the US. If TD bank starts to reduce funds for conventional mortgages – the others won’t be far behind. Very few people know this, but RBC provides a crap load of conventional money to monlines through RBC Dexia, Royal Trust, and RBC Dominion Securities. Most of the time when a retail investor has money sitting in their self directed RRSP account in cash, or money market, RBD is loaning it out the back door to monlines.

Differentials on bonds were always a ‘ thing ‘ and can change. Around July 1st 2020 the Canadian 5 year bond was 34.2 bps, while the US 5 year was only 26.6. Exactly different that where we are today. These differentials can flip flop all the time, but we are starting to see the gap widen and the differential seems to be going one way. Keep a watchful eye on it, as it will start to become important for investment in Canada. If investment dollars start leaving Canada en-mass, then that will also lead to other problems.