LRCNs Set to Overtake Prefs

Limited Recourse Capital Notes (LRCN) are shaking the world of preferred shares – and are likely to replace many of the existing preferred shares in the market now

Yan Barcelo 4 June, 2021 | 1:55AM
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Limited Recourse Capital notes, or LRCNs, are a new class of hybrid securities introduced about eight months ago. These products compete with preferred shares, shrinking that small universe significantly, but creating attractive opportunities in it for investors.

This Has Happened Before

This is not the first time something like this has happened. In the aftermath of the 2008 financial crisis, the world of preferred shares was transformed by the arrival of the new category of rate-reset preferred shares (RRPS). These new securities were still perpetual shares (with no predetermined term), except that on their five-year anniversary, the issuer could not only redeem them, but if it chose to leave them outstanding, it could also adjust the dividend up or down.

These RRPSs have completely changed the dynamics of this market. Not only do investors have to consider the possibility of a redemption of their securities, but they must gauge the spread that will prevail at the time of redemption and decide whether that spread is favourable to them or not. Thus, an already very complex mechanism has become even more complex.

Today, only 12 years after their introduction, RRPSs represent about 79% of total assets outstanding," says Steven Theriault, manager of the BNI Preferred Equity Income Fund at Intact Investment Management.

RRPSs are hybrid in nature in that they offer a yield like a bond, "but have more equity-like volatility," points out John Shaw, manager of the CI First Asset Preferred Equity ETF at CI Global Asset Management. On the other hand, "he adds, they are similar to bonds because of a low correlation to the equity market. " 

Yes and no. Fixed-interval revisions have profoundly changed the dynamics. When rates fall, unlike bonds, RRPSs remain exposed to falling interest rates," Theriault explains, "and when rates rise, they behave like stocks, but with a cap on upside potential because of issuers buying back their securities when the price of the securities is near or above their issue price ($25).

The low correlation to equities did not hold up during the March 2020 COVID crisis where the S&P/TSX preferred stock index declined by about 35%, as did the equity index. In 2018, according to a study from this year by TD Securities, RRPS exhibited puzzling behavior. In February of that year, when stocks were down -8%, RRPSslost just fractions of a percent and even held up better than the bond index. However, in October, while stocks were losing 7.8%, they were down -11.6% and bonds were still above water at +1.48%.

A Bully on the Block

Now appear LRCNs, a type of bill recently authorized in Canada by the Office of the Superintendent of Financial Institutions (OSFI). The Royal Bank of Canada set the ball rolling last July with a large issue of $1.75 billion, followed a few months later by another issue of $1.25 billion. This was unprecedented in the preferred shares market, "as the typical issue is between $300 and $500 million. Now, in a few months, RBC has financed $3 billion," says Theriault.

In the banking world, these LRCNs are expected to significantly slow down the issuance of RRPSs. This year, Alain Rhéaume, Senior Manager of the Desjardins Canadian Preferred Equity Fund at Desjardins Global Asset Management, expects at least $5 billion of RRPSs to be redeemed by Canadian banks, and the banks in most cases will not replace them with new RRPSs, but rather issue more LRCNs.

The high likelihood of a buy back greatly favours, for example, the BMO Series 40 of preferred shares, which Rhéaume has been stockpiling in the past year. This stock carried a coupon of about 6%, but the prospect of a buyback by BMO in 2022 is driving the price very positively. "It went from $20 to $22.50, and now it is at par," says the manager.

It is important to remember that LRCNs can only be bought by institutional investors, not retail investors. This comes with certain advantages for institutions. Shaw points out that the main one of these is taxation. RRPSs pay an after-tax dividend, while LRCNs, a bond at the outset, pay pre-tax interest income. This significantly reduces the bank's funding costs. Another advantage, as important as the first, is that, because they cater exclusively to the institutional market,  LRCN issuers can offer lower yields. A third advantage is the ability to issue larger amounts. The final advantage is easier access to capital compared to products sold to individual investors.

Managers are Pleased

And it’s not just banks. Insurers are also joining the party. These two sectors represent about 56% of the S&P/TSX Preferred Shares Index. In the current year, we can expect about 10% of the preferred shares market to be wiped out in favor of LRCNs, Theriault predicts, and then eventually it could reach 25%.

As of May 21st, Canadian RRPSs offered an average yield of 4.90%, significantly higher than the 4.47% yield of single B-rated high-yield U.S. corporate bonds and the 3.40% yield of BB-rated high-yield U.S. corporate bonds. At the bottom of the scale were five-year U.S. government bonds, with a yield of 0.82%, and Canadian bonds of the same duration, at 0.93%.

For bond managers, LRCNs can be a bonanza. Shaw bought Series 1 LRCN bills issued by Royal Bank last July, but he did so for another bond fund he manages, not for his preferred shares ETF. Compared to Canadian preferred shares, these notes, with a yield of 4.5%, are not attractive enough," he says. On the other hand, in the bond world, they are very attractive. "

As Rhéaume says, "Good times are ahead for preferred shares."

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About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, writing for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.

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