Rethinking the Preference for Preferred Shares
Author: Andy Kochar
September 25, 2020
Preferred shares have long been a go-to for Canadian investors seeking yield, but the market for “prefs” could shrink from structural changes currently taking place, leading to a necessary re-think of the various other income-generating options that can help anchor a well-rounded portfolio.
Granted, some investors have probably already thought this scenario through, but not everyone may recognize the extent of the challenges facing Canada’s preferred share market. For starters, “rate resets” – which make up the majority of preferred shares issued in Canada – have performed poorly due to stubbornly low interest rates in recent years and have not panned out as the investment many had hoped for when they were first widely introduced following the Great Financial Crisis.
However, more importantly, is the fact there has long been a desire among bank & life insurance company treasurers—who Bloomberg data shows represent about 50% of the entire pref market—to find an alternative structure for the purposes of raising capital more efficiently. This includes Canada’s biggest banks, whose preferred share issuance has been hindered by several inefficiencies, including high underwriting fees, poor liquidity and a relatively small retail investor base.
Global regulators, meanwhile, have also been eager to see changes that would redirect the ownership of these securities in the hands of more sophisticated investors. They tend to view prefs and other hybrid-type securities as overly complex and volatile for retail investors and would like share ownership in them to be more fully made up of pension plans, endowments and other large institutions.
Given these objectives, then, it’s not surprising that a replacement structure to preferred shares was recently issued and with more issuance of its kind expected in the future. Known as Limited Recourse Capital Notes (or LRCNs for short), this new form of financing has similarities to preferred shares, but is distinct in ways that clearly target institutional investors above all others. Namely, LRCNs come with minimum par values of $1,000 compared to $25 for prefs and require a minimum initial purchase of $200,000. Coupons on an LRCN are also paid out of pre-tax income, which much like a bond, results in a tax benefit for the issuer. Of course, this differs from preferred shares, where dividends are paid by the issuer out of after-tax income resulting in a dividend tax credit for the investor.
While it’s still too early to call LRCNs an unequivocal success, it’s easy to see how their expected proliferation could lead to a sizable reduction in the preferred share market as we know it. Bank and insurance prefs, for example, represent about 50% of the rate reset market currently, according to Bloomberg data, and about $12 billion of that are callable sometime between now and 2022. Looking at the profile of these structures, we expect the vast majority of these issues to be called because of the level of reset spreads in the back end. More to the point, a vast majority of these issues have sizeable reset spreads that can be easily refinanced in the LRCN market at cheaper levels, providing issuers the added benefits of tax deductibility and lower underwriting fees.
Needless to say, the future may not be bright for preferred shares, nor for retail investors who have become overly dependent on them to generate income in their portfolios. How then does the potential void left by a diminishing pref market get filled?
The key, as always, is diversification. In fact, given the unique characteristics of preferred shares, including their preferential tax treatment, it’s unlikely that any one fixed income investment or category can replace them. Instead, investors would be smart to incorporate a range of different options including corporate credit and emerging market bonds, as well as a sleeve of dividend-paying equities. Collectively, these categories offer a competitive yield to preferred shares with a reduced level of liquidity risk given how much larger both investment grade and high-yield bond markets are compared to prefs. A greater emphasis on credit, which is placed ahead of preferred shares in the capital structure of a corporation, also potentially reduces the amount of solvency risk in a portfolio.
So, not only can investors get by without a heavy reliance on preferred shares going forward, they may end up being better off.
Andy Kochar is a Portfolio Manager and Head of Credit at AGF Investments Inc. He is a regular contributor to AGF Perspectives.
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