As preferred shares are called and conventional bonds offer mediocre rates, investors are turning to limited recourse capital notes (LRCNs).
LRCNs launched in July 2020, aimed at institutional investors. With their 60-year terms, LRCNs offer good yields and attractive features for issuers, acting as bond substitutes and shock absorbers. Banks and insurance companies can now issue LRCNs. Earlier this month, Great-West Lifeco Inc. issued $1.5 billion in LRCNs with an annual fixed rate of 3.6%, matching the rate offered by Toronto-Dominion Bank in its July release.
The instruments are complex, but restore positive real yields to debt markets.
As of Aug. 19, 10-year Canadas pay 1.13% and 10-year U.S. Treasuries pay 1.24%. Provincial bonds can add 70 basis points. Strong corporate bonds with similar maturities can add another 120 basis points, depending on rating, but those yields generally remain below inflation, which in Canada hit 3.1% in June.
Some of this inflation reflects supply chain interruptions, but as those issues resolve, prices of many goods will settle down. But trillions of subsidy and emergency relief dollars remain ready to be lent. As a result, locking into a conventional bond in this market seems to make little sense for an investor who just wants to make money with acceptable risk.
“Ten-year federal bonds in Canada and the U.S. have low yields because their economies are flooded with cash generated through bond-buying programs of the Bank of Canada and the Fed,” said James Hymas, president of Toronto-based Hymas Investment Management Inc., which specializes in preferred shares.
Investors are ahead of the markets in wanting yield. That has traditionally been provided by preferreds — especially rate-resetters, which move down in price when interest rates fall and should move up when rates rise.
But resetters are becoming scarce. Companies facing rising costs on their outstanding resetters are calling them: 65% of resetters are being called at $25 (their issue price), limiting their upside. Add to that reduced issuance, limited liquidity, high underwriting fees for issuers and poor liquidity for most issues, and all preferreds are dowagers in a market that likes debutantes.
Moreover, resetters have not consistently balanced equity risk.
In October 2018, as stocks dropped 7.8%, resetters dropped 11.6% while bonds rose 1.48%. But in the March 2020 Covid-19 panic, the S&P/TSX preferred stock index dropped 35% — right along with the broader equities index. Friends like these an investor doesn’t need.
Enter LRCNs. With minimum par values of $1,000 and a minimum purchase of $200,000, LRCNs can only be issued to institutional investors. The instruments are seen as senior credit by markets — though they technically rank with the prefs they are replacing and are thus lower than subordinated debt.
LRCNs are not included in bond indexes because they aren’t bonds and they are backed by perpetual non-cumulative preferred bank shares. Their superior yield over other bank capital — about 2% to 4% — reflects their inherent risk.
If LRCNs could be sold to individual investors, they would have some advantages. “LRCNs, which pay interest from pre-tax income rather than dividends, [would] not trigger the dividend tax credit for investors drawing old age security and thus [would] have the advantage of not causing the OAS clawback at the income levels at which preferred share dividends do,” said Caroline Nalbantoglu, head of CNal Financial Management Inc. in Montreal.
Even so, however, LRCNs’ lack of liquidity makes them unsuitable for most retail investors. LRCNs are long dated with 60-year maturities. That implies that investors must actively ensure the spread they are getting over 10-year Canadas reflect their risk.
Bottom line: LRCNs are hybrids from big issuers for institutional buyers, but they remain long-dated prefs at heart. As Hymas put it: “LRCNs are preferred shares with new wrapping paper.”