The End of Preferred Shares?

LRCNs are set to be a game-changer, says Fiera Capital's Nicolas Normandeau - Could this mean the end of preferred shares?

Ruth Saldanha 25 August, 2020 | 1:47AM
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Ruth Saldanha: RBC's recent $1 billion limited recourse capital notes called LRCNs received a lot of interest prompting speculation that this new product would take off with other banks and financial services firms and eventually lead to the end of the preferred shares. Fiera Capital's Nicolas Normandeau is one of Canada's largest managers of preferred shares. He expects close to $11 billion in preferred share redemptions over the next 24 months and calls LRCNs a game changer for the market. He is here today to talk about why. Nicolas, thank you so much for being here today.

Nicolas Normandeau: You're welcome. Hi.

Saldanha: First, why are preferred shares rallying right now and why do you expect this amount of redemption?

Normandeau: Well, like you said, the LRCN did by RBC in July was a game changer. The pricing they were able to get was much better than the preferred share market valuation, right, so for the issuer. And the fact that they might print up to $16 billion, $17 billion of those LRCN over time means that we could see lots of preferred share redemption because right now these resets level that some of them that has 400 resets and better are much more expensive versus the LRCN. So, like you mentioned, we might see close to $10.8 billion of redemptions, and that's 16.5% of the overall preferred share market. That's a lot. So, of course, the market rallied strongly on that and I think there's much more to go.

Saldanha: So, what does this mean for retail investors who own preferred shares even though mutual funds or ETFs?

Normandeau: Well, that means that finally they are going to make money. It's been three difficult years for them. Seeing all these potential redemptions – it's not for sure that we'll see the redemptions. If the market tone remains okay, yes, we should expect those redemptions coming. So, that means, let's say, they own an ETF or a fund if it's passively managed, let's say, while these funds will be at some point full of cash and usually, they cannot hold that much cash where they will go and try to shop the preferred shares outstanding. So, they are going to put an upside price on all of them. Some of the other investors might buy the LRCNs. But what we could say, this is a net positive seeing that much potential redemptions for sure.

Saldanha: Do you see this as being the end of the preferred share market in Canada?

Normandeau: No, not necessarily. It's fair to say that the market will change a lot. As you know, there is a limit of those LRCNs that the banks can print. It's 50% of their AT1 bucket which is 75 basis points which is like we mentioned $17 billion. So, it's fair to say that as the market is really now cheaper for them to issue an LRCN, they're going to focus on that market. But as we will see redemptions in the pref market, I think that maybe valuation will become more expensive on the pref market and maybe at some point for those issuers, they are always looking at what are the cheapest options for funding. So, maybe down the road, maybe in two, three years the pref market will become the cheapest solutions for them instead of LRCN.

But it's fair to say that the market will change. Going forward, we will see less banks issuance, less life insurance issuance, less or even nonfinancial company issuance because these guys do have other options, so maybe less diversification of issuers going forward. That's maybe in three, four, five years. And it's also fair to say that the reset level of the overall preferred market will be lower. Because all the 400, maybe the 300 at some point will get redeemed. So, the market will change a lot, but this will take time and right now, to stick with the asset class is the right thing to do or even increasing your exposure, because all the upside is coming.

Saldanha: Now, LRCNs are issued by banks. What happens to non-banking financial institutions and indeed, non-financial services companies like say Enbridge that issue preferred shares right now, will they be able to issue LRCNs?

Normandeau: It's unclear now yet. Right now, OSFI gave the capital treatment for banks and also life insurance. So, after that, let's say, a company like you mentioned, Enbridge, right now they already have the options of printing a preferred or an hybrid. Hybrids is also interest. So, there are savings on that too like the LRCN. But I would suspect these non-financial companies to look at the LRCN as I think it's a better structure versus the hybrids. It's treated as equity forever. They will have to talk with the credit agencies on that like it's different versus that banks needed to talk with OSFI on those. But assuming that they get the approval from the credit agencies, it's going to be a cheaper option, a better option for them versus issuing the hybrids. But that's again, it's assuming that there will be demand too on the investors' side. It's all good being able to print those, but if there is no demand, it's going to be impossible. So, that's going to be remain to be seen. But I think that with the really strong credit environment we're in, I think they might be able to do it.

Saldanha: At present, LRCNs are only available for institutional investors. How can retail investor participate with this product and what are some of the risks for LRCNs versus preferred shares for retail investors?

Normandeau: Yeah, you're right. That was one of the conditions of OSFI to be – like retail investors were not able to buy this under new issue. Of course, they can buy it in the secondary market if they want. But new issue it's only for institutional investors. So, retail investors, if they want to buy this, they can buy it through corporate bond funds that some of them might buy these LRCNs or funds like the funds we manage, the preferred share that we also have the opportunity to buy them if we think they are attractive.

What are the risks? It's exact same risk as a preferred share. So, you have extension. You have further credit risk. You are deeper in the capital structure. After that, it's exactly the same the risk as a pref as you can get extended for 60-year. It can be converted into a pref. It can stop paying the dividend. So, you should expect similar volatility than a preferred. So, not because it's LRCN that you won't have the same volatility. But I think the good thing is that liquidity will be better within these LRCNs versus the preferred share market. And I would suspect that the market pricing or valuation will always be similar, let's say, to the global hybrids market, while lately, the preferred share market in Canada because it was not much demand was really lagging all the hybrids in the world. So, on that, I think it's a positive. But investors let go like the dividend advantage within the pref that because the LRCNs are interesting. So, this is less advantage. So, there is good and bad, I would say, for investors. But for risk, it's exact same thing as a pref.

Saldanha: Thank you so much for joining us today with your perspectives, Nicolas.

Normandeau: Thank you. Thanks for having me.

Saldanha: For Morningstar, I'm Ruth Saldanha.

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Ruth Saldanha

Ruth Saldanha  is Editorial Manager at Follow her on Twitter @KarishmaRuth.


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