Institutional investors have a brand new security in which to invest: limited recourse* capital notes (LRCNs). The notes are secured with preferred shares that convert to common equity only if the issuing entity becomes non-viable.
In July, the Office of the Superintendent of Financial Institutions (OSFI) approved the new structure and provided issue terms for chartered banks. (OSFI is developing rules for insurers.)
The notes have 60-year terms backed by perpetual preferred shares; those underlying preferreds are non-cumulative and non-redeemable. Issuers, in other words, don’t have to give the money back or make up for missed dividends.
The structure means the issuer can deduct interest payments, consistent with Canada Revenue Agency rules for bonds with terms of less than 100 years. Furthermore, OSFI recognizes LRCNs as additional Tier 1 regulatory capital. This recognition means banks have a cheaper instrument with which to raise Tier 1 capital than common or preferred shares.
John Shaw, head of investment-grade credit and preferred shares with Signature Global Asset Management in Toronto, says engineering the new notes creates a high-yield device in a tightly regulated sector.
On July 21, Royal Bank of Canada became the first institution to issue LRCNs, raising $1.75 billion. (The Globe and Mail reported demand for the issue was more than double supply.) Each note has a face value of $1,000 and matures in November 2080.
Non-accredited investors need not apply — in fact, OSFI told issuers not to solicit retail accounts. Furthermore, the LRCNs will not be board-priced or tracked in major bond indexes because the notes do not include a solid promise to return capital. Access to pricing information will be via traders’ bond desks only. Some bond funds may have difficulty buying these notes because they lack the promise of redemption intrinsic in bonds.
James Hymas, president of Hymas Investment Management Inc. in Toronto, says that since the issuing banks are not required to redeem LRCNs at maturity, “they are not really bonds.”
LRCNs come with an attractive return: 4.5% for five years, reset every five years at the Government of Canada five-year bond rate plus 4.137%. The return far exceeds the return on bank-issued senior bonds of similar term, consistent with LRCNs’ higher risk. The notes’ premium over other bank-subordinated debt makes LRCNs attractive on their own merits, says Hymas.
LRCNs rank in priority of payment below former non-viability-contingent capital but ahead of ordinary preferreds, explains Chris Kresic, head of allocation and fixed-income with Jarislowsky Fraser Ltd. in Toronto: “The attraction for issuers is that the money they pay is not preferred income, but tax-deductible interest.” Banks also can distribute the underlying preferreds in lieu of cash.
Geof Marshall, head of fixed-income at CI Investments in Toronto, says the bonds fit the times: “Interest rates are not going to rise for a long time. The underlying asset, the perpetual preferreds, have a 10-year call and five-year interest resets. So the real term is five years, but the credit spread over conventional corporate bonds is much larger if the issuers do not call. In good times, LRCNs will behave like bonds; but if issuers are in financial difficulty, they will be orphans in search of a home.”
Given the complexity of LRCNs, who will buy them? Bond funds with broad mandates will, suggests Hymas. (Indeed, Marshall says he has bought them for several CI portfolios.)
LRCNs also get Canadian taxpayers off the hook in the event that a chartered bank needs more capital. “There is no reliance on taxpayer money,” Shaw says, because LRCNs convert to equity in a crisis at unfavourable terms for holders.
For both issuers and OSFI, the new hybrids are win-win investments.
*The original version of this article called the instruments “limited resource capital notes.” They are “limited recourse capital notes.” Return to the corrected sentence.