The TSX Preferred Share Index rallied hard on July 8 and 9, 2020, up 6.7% over the two days combined, though it was down about 70 basis points (“bps”) as at July 17, 2020, with news of RBC issuing $1 billion worth of new Limited Recourse Capital Notes (“LRCNs”).
We will provide more details on this new structure in an upcoming update, but the basics are: the new note is legally a bond, so it’s considered to be debt by OSFI; its coupon resets and is redeemable every five years at the five-year Government of Canada yield, plus the initial credit spread, with a 60-year final maturity; it has recourse only to equivalent preferred shares that are concurrently issued to a special purpose vehicle, and is converted into those preferred shares upon any missed interest/principal payment, upon an event of default or if the bank does not pay the redemption price at maturity.
The notes are issued only to institutional investors, meaning retail investors won’t have access to them. They rank pari-passu to preferred shares; lower in the capital structure than bonds, but higher than common equity. The LRCN market is likely to be fairly liquid going forward, as institutional interest in the asset class should be strong (institutions are not huge holders of preferred shares).
Why the rally? As is not uncommon in the preferred share market, the story comes back to liquidity. With its consideration as debt, the payments from LRCNs become tax-deductible for the issuer, and thus, more attractive than issuing preferred shares in certain cases. Considering that, it’s safe to assume that, going forward, we may see reduced preferred share issuance by banks, so a scarcity premium is now being baked into the existing preferred share market.
Moreover, there will likely be redemptions on reset dates; any bank/insurer issues with resets over approximately 350 have a fairly high probability of being redeemed, so we’ve seen those issues rally particularly hard. With its interest income as opposed to tax-advantaged dividends, LRCNs are not quite as attractive for the retail crowd, but as mentioned, it’s not available to them anyway.
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