Read on Twitter
One development Canadian investors may have missed in July was the new issuance by the Royal Bank of “AT1” preferred notes. While not quite “the shot heard around the world,” we believe it will be a catalyst for the Canadian pref shares market <THREAD> https://www.penderfund.com/commentaries/pender-fixed-income-managers-commentary-july-2020/
2/ To understand the significance of the move by $RY, it is useful to begin with some context - that being the options currently available for $CAD fixed income investors with comparatively low tolerance for credit risk. In short, this market is a yield desert...
3/ For instance, the 10 year Government of Canada bond recently was priced to pay out 4.3%. And no, that’s not ANNUALLY, that’s CUMULATIVELY...in other words 0.43% p.a. Going into investment grade bonds in Canadian dollars moves the return up somewhat above 1% p.a - thin gruel...
4/ What is odd, in this context, is the roughly $60B Cdn pref share market. Cdn pref shares are yielding between 5-7%, or about 5x the yield of the Cdn IG bond market. Pro-tip, the issuers are largely the same companies!...
5/ Some reasons for a small gap in yields between Cdn prefs and IG bonds. Many Cdn prefs are Rate-reset or indexed against a benchmark yield ( the 5 yr Canada or the prime rate). These benchmarks have been declining although one could argue they are approaching the lower bound...
6/ There are other reasons for prefs to trade wide of bonds, structural subordination, and smaller issue sizes included. But OTOH pref dividends are paid after-tax, while interest is paid pre-tax, meaning to a taxable holder pref divvy is worth ~1.3x an interest coupon...
7/ But all these reasons don’t really explain the huge chasm of a gap between Cdn IG bond yields of 1% and pref dividend yields of 6%. The reason for this is, I believe, a difference in the sets of investors who are involved in the two markets...
8/ Cdn IG bond investors are large institutions and funds, flush with cash and pushed to the edge of their risk limits by the BoC and the global plunge in the risk free rate. OTOH Cdn pref share investors are small accounts, individuals and advisors, still shaken by March2020...
9/ While the big funds and institutions active in the Cdn IG bond market would LOVE to access the yields available in the pref market, they can’t...risk committees, benchmark indices, and prospectus rules interfere in many cases. ... And so here we return to $RY and the AT1 issue
10/ What $RY and OSFI worked out was an AT1 structure that allowed the bank to issue preferred equity capital inside a wrapper that looks enough like a bond to be buyable by the big institutions playing in the Cdn IG bond market...
11/ And voila, investors who couldn’t buy 6% yields in tax-advantaged $RY prefs are lining up seven rows deep to buy 4.5% tax-disadvantaged AT1 notes. It’s like two lakes exist at different altitudes and the AT1 note is a freshly dug canal connecting them...
