Impact On the Market
RBC’s $1.75 billion offering of Limited Recourse Capital Notes (“LRCNs”) announced last week is likely to be the first of a series of similar offerings from other Canadian banks and insurance companies regulated by the Office of the Superintendent of Financial Services (“OFSI”), as LRCNs now allow them to meet their additional Tier 1 (AT1) capital requirements at a lower financing cost than with preferred shares.
RBC’s LRCNs pay 4.5% interest for the next five years, which is equivalent to a dividend coupon of 3.6% (using a factor of 1.25x interest/dividend to account for tax treatment) or a reset spread of 325 basis points (“bps”) over the Canadian five-year rate. When we compare it to preferred share RY.R, for example — which has a reset of 480 bps and is callable on August 24, 2021 — we can see that LRCNs provide issuers with much cheaper financing than some preferred shares.
Consequently, the extension risk for banks’ preferred shares with resets over approximately 350 bps has decreased significantly as they will likely be redeemed on their respective call dates over time, subject to the issuer’s limit on LRCNs (the limit is currently 50% of the AT1 bucket limit for banks and is subject to changes). These issues, with resets over 350 bps have rallied significantly following the announcement, with some of them gaining as much as 15%. The rally has been even broader thanks in part to the expected ‘scarcity effect’ on the preferred shares market and the large presence of passive ETFs in the preferred share market; some banks’ preferred shares with resets less than or equal to 250 bps, which have a low probability of redemption, have also gained about 10%.
The impact of LRCNs on the S&P/TSX Preferred Share index is expected to be material in the future and won’t be limited to the banking sector. We believe that insurance companies will likely follow suit, as they also meet the requirements to issue LRCNs (confirmed by OSFI in its ruling letter). In addition, as financial preferred share issues with resets over approximately 350 bps are redeemed over time (up to the issuer’s limit on LRCN), non-financial preferred shares will occupy a higher weight in the index, which will prompt market participants to rebalance. Importantly, non-financial issuers such as utilities and energy issuers also have access to the hybrid market, which we expect to also limit supply.
Impact on Fiera Capital Positioning
While no Horizons ETFs managed by Fiera Capital participated in RBC’s first LRCN, as in our opinion we can find better opportunities within preferred shares, we may buy LRCNs in the future should they become more attractive relative to preferred shares and to U.S. dollar hybrids (senior to LRCNs).
Overall, the strategy is well-positioned and currently benefitting from its exposure to mid-high rate reset financials (banks and insurers). We remain opportunistic in non-viable contingent capital (“NVCC”) bonds from banks and insurance companies, as we expect insurers to have access to such AT1 funding instruments in the future, as well as preferred shares with resets above approximately 350 bps. Our strategy includes exposure to the highest yielding rate-reset preferred shares, which we believe have the highest likelihood of redemption and have a fair valuation.
The views/opinions expressed herein may not necessarily be the views of Horizons ETFs Management (Canada) Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors.
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