A New Additional Tier 1 (AT1) Security – Canadian Preferred Share Market Update

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​A New Type of Preferred Share Structure

On July 15, 2020, Royal Bank of Canada (“Royal Bank”) held a roadshow to announce a new form of Additional Tier 1 (AT1) security that the Office of the Superintendent of Financials Institutions (OSFI) had approved. The structure had solved the conundrum facing Canadian banks since the old Innovative Tier 1 bonds had been deemed non-compliant following the Global Financial Crisis of 2008. This security overcomes two conflicting requirements in that AT1 securities must be considered perpetual to be approved by OFSI, however, to receive interest deductibility from the Canada Revenue Agency (CRA), the security must have a maturity date of less than 100 years.

The structured security, called a Limited Recourse Capital Note (LRCN) has two parts:

  1. A bond paying interest with a maturity of 60 years, issued from Royal Bank of Canada. However, if a default event occurred or OSFI triggered a Non-Viability Contingent Capital (NVCC) clause, then the holders only claim is on a preferred share (see #2) with the same terms except no maturity date that is held in trust.
  2. A preferred share with no maturity date and NVCC eligible, but with the same coupon and re-set spread as the LRCN is held in trust.

The LRCN ranks equal to a $25 par preferred share and has the same NVCC multiplier of 1.0 times and a minimum common share price of $5. This LRCN structure is much more cost effective for the bank, as the interest payments are counted as an expense, as opposed to preferred dividends that are paid with after tax earnings.

OSFI set a maximum amount of LRCNs that a bank can claim as capital at 50% of its AT1 bucket or 0.75% of Risk Weighted Assets (RWAs). They noted that the rules could change in the future, which I read as meaning it could go higher. Interestingly, OSFI also said that the LRCN could not be sold to retail investors. It seems that OSFI does not want “Mom & Pop” investors hurt if it has to convert the preferred shares into common equity to re-capitalize a failing bank. 

At 0.75% of the Big 6 banks RWAs that could mean up to $16 billion of issuance in this new security. Royal Bank issued $1.75 billion LRCN at 4.50% with a 60-year maturity and is non-callable for 5 years. The bank can decide to leave the bond outstanding beyond 5 years, but the coupon is re-set at the then current 5-year Government of Canada 5-year bond yield plus the original spread of 413 basis points (bps).

Signature participated in the new LRCN structure issued by Royal Bank.

Bond Market Consequences

The implication to this announcement is very positive, as it’s a new higher yielding bond from a highly regulated and profitable sector, however it is a very junior security. The LRCN was not added to the Canadian bond index, so it becomes a way for active portfolio managers to take out-of-benchmark positions to potentially outperform. There is a lack of higher yield debt in the Canadian market so the issuance should be easily absorbed by the market.

Preferred Share Market Consequences

This is extremely positive for higher rate re-set preferred shares issued by banks as they are now very likely to be redeemed at the next call date and be replaced with LRCNs. All bank issued preferred shares have benefitted from the announcement of the LRCN and we would expect at some time in the future for OSFI to increase the amount to 100% of AT1 bucket.

Under the current limits, we estimate that $9.5 billion of preferred shares may be redeemed, which represents over 15% of the Canadian $25 preferred share. Even all the lower re-set spread bank preferred shares may be required to be redeemed, if OSFI truly does not want retail investors holding individual preferred shares in the future. This will likely take some time, with a high chance that most of the lower re-set spread preferred shares will be re-set at least one or two more times before it happens. The banks are still working down the old non-NVCC AT1 bonds and preferred shares. OSFI has given the banks a 10-year amortizing schedule to reduce them, which ends November 1, 2021.

LRCN issuance is likely to be used to:

  1. Redeem non-NVCC bonds and preferred shares coming up for redemption over the next 18 months,
  2. Fill unused AT1 bucket
  3. Redeem outstanding high re-set spread preferred shares at their next redemption date.

Each bank has a different set of circumstances so its difficult to predict exactly which preferred shares will be redeemed other than the 400+ re-set spread preferred shares.

OSFI also mentioned that they are working on rules for Insurance companies along the same lines as the banks, with more details to follow. This would certainly result in even more preferred share leaving the market.

General Sources Used: Bloomberg Finance L.P.

How to Access Preferred Share Strategies with Signature

    Fund Codes (CIG)

Fund

Morningstar Star Rating Overall Class A (ISC) Class F
Signature Preferred Share Fund ★★★★ 2346 4346
CI First Asset Preferred Share ETF ★★★★ TSX: FPR

 

Standard performance – as of June 30, 2020

Investment

YTD

1-year

2-Years

3-years

Inception Date

Since Inception

CI First Asset Preferred Share ETF (FPR)

-10.4%

-6.3%

-6.6%

-2.8%

5/11/2016

1.7%

Quartile Rank

1

1

1

1

 

1

Signature Preferred Share Fund Class F

-11.2%

-6.7%

-7.1%

-3.2%

12/21/2015

1.7%

Quartile Rank

2

1

1

1

 

1

S&P/TSX Preferred Share Index

-11.2%

-7.2%

-8.3%

-4.0%

6/12/2007

1.0%

Preferred Share Fixed Income Category

-12.1%

-8.2%

-9.0%

-4.8%

3/31/2013

-1.2%

# of funds in category

78

77

71

65

 

ETF: 51
Fund: 47

Source: Morningstar Research Inc., CI Investments

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For Signature Preferred Share Fund, the star ratings and number of Preferred Share Fixed Income category funds are as follows: overall – 4 stars; 3 years – 4 stars, 65 funds. For CI First Asset Preferred Share ETF (FPR), the star ratings and number of Preferred Share Fixed Income category funds are as follows: overall – 4 stars; 3 years – 4 stars, 65 funds

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Published August 6, 2020.

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