How To Make 9%+ Annually With Canada's Big Bank Preferreds

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Includes: BMO, BNS, CM, NTIOF, RY, TD
by: Kevin Wiens

Summary

Regulations in Canada have changed, which has changed what types of securities can be counted as regulatory capital.

This change means that many current issues of preferred shares will be redeemed before 2022.

A number of these issues are priced to give 9%+ annual returns to the next redemption date.

While not record-setting returns, I believe these are solid returns that can be had with minimal risk.

Before we get started

I am writing this article from the perspective of a Canadian investor under Canadian regulations. I do not know if any of these arguments are valid in the U.S. Further, I will often generalize an entire class of assets, even though individual issues may have differing terms and conditions. I have written the article with a view toward preferred shares of the big banks; while some of the information is applicable to other issuers, please realize that I am generally talking about bank securities.

Introduction

If you're anything like me, you probably know what a preferred share is. The basics; textbook stuff. You learned it in school or picked it up somewhere along the way. There is a huge market for these securities and Canada's so-called Big Six Banks - Royal Bank (NYSE:RY), TD Bank (NYSE:TD), Scotiabank (NYSE:BNS), BMO (NYSE:BMO), CIBC (NYSE:CM) and National Bank (OTCPK:NTIOF) - are no slouches in the game, having issued billions of dollars of these shares.

Being the young risk taker that I am (or was), I had never really investigated further, viewing them as more fixed-income-like than I was looking for. That is, until I read an article that sent me down the rabbit hole of the effect that changing regulations will have on these normally docile securities. It just so happens that I fell down the rabbit hole at the same time these shares are falling into their own abyss. Fixed-income-like as they may be, I believe the current environment provides an opportunity for solid returns with little risk.

Let me explain.

Background

Before I get into the meat of my article, I think I should start with some background info.

Regulations

The Basel III regulatory framework was developed in response to the financial crisis, which revealed some deficiencies in previous regulations. Part of this change was an amendment to the definition of regulatory capital.

Without going into too much boring detail (you can read all about it here), OSFI updated its Capital Adequacy Requirements for banks, which introduced Non-Viability Contingent Capital (NVCC) requirements that require all non-common Tier 1 and Tier 2 capital instruments to have in their contractual terms a "clause requiring full and permanent conversion into common shares of the institution upon a trigger event." These updated regulations applied as of January 1, 2013. Existing securities that were previously counted as regulatory capital are subject to a phase-out schedule, shown in the following table.

(Source: OSFI - linked to above)

So, for example, 60% of non-compliant issues that were outstanding prior to the rule change will be counted as regulatory capital in Q1 2016; 50% in Q1 2017, and so on. Basically, for issues that were previously considered regulatory capital and are now being grandfathered into the new regulatory environment, every year the banks will be able to count less and less of the issue as regulatory capital.

Rate reset preferred shares

Rate reset preferred shares are basically preferred shares that reset their dividend rate every five years (individual issues may vary). Generally, they are issued with a stated spread to the five-year Canada bond rate. When the rate reset date (what I refer to as the five year anniversary date in this article) comes up, the dividend rate is reset at the prevailing bond rate plus the stated spread (which was set at the time the shares were issued). Generally speaking, it is on this five year anniversary date that the issuer is able to redeem the shares.

These instruments started to appear in 2008, back when interest rates were falling and people thought it would be a temporary situation. Investors liked them because they offered some protection to (anticipated) rising rates.

Rate reset preferred shares, just like other preferred shares, are generally perpetual in nature; that is, unlike a bond, there is no fixed maturity date and there is generally nothing forcing the issuer to redeem the units. Investors will often use these shares as bond substitutes, as they generally pay a higher yield than common shares and are ranked higher than common shares in a liquidation scenario.

Tying it all together

Although the regulatory changes outlined above do not require the banks to redeem NVCC non-compliant issues, my thesis is that the banks have the incentive to redeem these units and issue NVCC compliant issue in their place in order to include the capital for regulatory purposes. After all, why have shares outstanding that do not count toward regulatory capital when you can just swap them with shares that do count?

In my mind, the new regulations have created an implicit redemption date on non-compliant preferreds. Further, because rate reset shares can only be redeemed on five-year anniversary dates, many of these issues have only one redemption date remaining before 2022 (at which point 0% of the issue will be counted as regulatory capital). Basically, the new rules have turned perpetual shares into a more bond-like instrument, with defined cash flows (quarterly dividends and a fixed redemption date).

Where do we stand today?

The anticipated higher interest rates never came. In Canada, benchmark rates have been dropping since the beginning of 2015. It was at about that time that rate reset preferred shares started to slide. The chart below shows the five-year unit price for the Claymore S&P/TSX Canadian Preferred ETF (CPD's product page).

(Rate reset shares are said to account for roughly 60% of the Canadian preferred share market. I will note that this ETF is not a proxy for the issues I am talking about, which are rate reset preferreds issued by the big banks, although it is indicative of how the bank shares have been trading.)

Presumably, investors are ditching the rate reset preferreds due to declining benchmark rates and upcoming rate reset periods, with many of the rate reset preferreds issued by the big banks joining in the collapse.

However, as pointed out above, the chances of the banks redeeming their non-compliant rate reset preferreds over the coming years is quite good. Declining share prices simply serve to increase what I will refer to as the yield to redemption (that is, the IRR of an investment assuming the shares are redeemed at the last possible redemption date prior to 2022).

I've included below a list of all rate reset preferred share issues from the big six Canadian banks. The list is sorted by next redemption date. (Please note that this was a manual process collecting the information from the various banks' investor relations pages which means that this may not be an exhaustive list and it is subject to human error.)

(Sources: RBC, TD, Scotia, BMO, CIBC, National Bank.)

If we compare the current yield on compliant issues versus the current yield on non-compliant issues, we can see what I believe to be a rational market; that is, non-compliant issues are yielding less than compliant issues as their prices have been supported by anticipated redemptions. (An additional explanation is that non-compliant shares do not have triggers that would convert them into common shares, which makes them worth more to an investor.)

(Source: data gathered from banks' investor relations pages as presented in table above.)

Narrowing down the list

Because I want to take advantage of the regulatory rule change, I am only interested in non-compliant shares. While it is possible for compliant shares to be redeemed at the next redemption date, I believe it is unlikely: First, these shares are already compliant with the new regulations and will be counted as regulatory capital going forward. Second, as seen near the bottom of the full list, recent issues of NVCC-compliant shares have higher spreads (meaning there is no financial incentive for the bank to replace already-compliant lower-spread issues). The following graph illustrates the latter point.

(Source: data gathered from banks' investor relations pages as presented in table above.)

(The two high-spread issues from 2009 have since been redeemed.)

Given that there are only 12 non-compliant rate reset preferred shares trading at this time, I calculated the annualized yield-to-redemption for each issue.

There is a caveat for the BMO.PR.Q issue, for which the next redemption date is in August 2016. This redemption date allows for the rate to be reset in August 2016 and for the shares to be redeemed at the following redemption date in August 2021, prior to the 2022 deadline. For this issue, IRR 1 represents the annualized yield-to-redemption assuming the shares are redeemed in August 2016 and IRR 2 represents the annualized yield-to-redemption assuming the shares are redeemed in August 2021. There is a further assumption in IRR2 that Canadian Government 5-year bonds are trading at 0.75% at the time of the rate reset in August 2016.

It is possible that BMO will redeem these shares in August 2016 (which would provide a very nice return over a six-month timeframe). While I am not ruling out this possibility (due to declining inclusion rates during the phase-out period discussed above), I believe it is not the probable outcome (due to widening spreads on new compliant issues).

(Source: data gathered from banks' investor relations pages as presented in table above.)

(Prices are as of market close on February 29, 2016.)

As we can see, there are a number of issues that provide healthy annual returns (well above face value yield) over various timeframes. (It is worth noting that these shares do fluctuate with the market and the patient investor can likely find them trading at lower prices and, hence, higher IRRs.) While these returns will not set the world on fire, I believe that the odds are good that these rate reset preferreds will be redeemed at the next possible date (with a caveat again for the BMO.PR.Q issue). As such, I believe these returns can be had with relatively little risk. I like making money and I will gladly take a low-risk 9% annual return over four years.

What can go wrong?

I am not a lawyer and I do not know the new regulations inside and out. I have read parts of the OSFI rules and various prospectuses, but I do not claim to be an expert. The arguments I have presented are based on my understanding of the regulatory environment and the terms of the preferred shares. There is a risk that I am wrong in my understanding.

The following are additional possible risks:

  1. Changing regulatory environment. In this day and age, this is definitely a risk; however, my guess is that regulations will not be relaxed any time soon. I think that after the past decade, if anything, regulations will only become more stringent.
  2. Rate resets converting into floating rate preferreds. Generally speaking, these rate reset preferreds can be converted into floating rate preferreds (which have floating quarterly dividend payments that are (usually) calculated as a spread to the 3-month Government of Canada T-Bill rate). These floating rate preferreds do not have fixed redemption dates and can be redeemed at any time. Because these floating rate shares are also NVCC non-compliant, I believe it is likely they will also be redeemed prior to 2022; however, because they can be redeemed at any date, there is the possibility they will not be redeemed until December 2021. With the return of principal representing a large part of my calculated IRRs, delaying the return of principal will reduce the IRR.
  3. Declining interest rates. This is a realistic possibility in Canada in the near future. If rates decrease, it is likely that these preferred shares trade lower. However, because I am viewing these preferred shares like bonds with a fixed redemption date, I view the IRR as locked in upon purchase - a lower share price just serves to increase the yield-to-redemption on any new purchases.
  4. Credit risk. This is always a risk. However, the shares listed above are all issued by the largest six banks in Canada and I do not anticipate any of them going under in the next five years, let alone within my lifetime. For what it's worth, preferred shares rank above common shares in a bankruptcy scenario.
  5. The banks don't redeem the shares. Although this goes along with my first risk (of me being wrong), I think this point is worth re-iterating: the new regulations do not require the banks to redeem NVCC non-compliant preferred shares; rather, they create the incentive for the banks to redeem. Although I do not believe it likely, there is a chance (even if it is close to 0%, in my opinion) that the banks do not redeem the shares. In this case, my thesis flies out the window. At that point I will be selling my shares; likely for a loss.

Which issues am I looking at?

Generally speaking, I view all of these issues as more or less the same. For the most part, their prospectuses follow the same format and contain the same provisions. Therefore, I have focused on those shares that provide the highest IRR, although I will highlight three exceptions.

The first is BMO.PR.Q, which has a rate reset date (and hence, a possible redemption date) coming up in August. This issue intrigues me because if the shares are redeemed in August, the total return on the trade would be about 45%. As a back-up prize, if the shares are not redeemed in August, the trade will likely provide an annual return of over 9% (assuming my estimate of a 0.75% Canada bond rate at the reset date is close to correct).

The second exception is BNS.PR.Y. This issue, technically referred to as Series 30, has a sister share outstanding (Series 31 - BNS.PR.D), which is basically the floating rate equivalent of the Series 30 share. That is, instead of resetting the dividend rate every five years, the dividends on the floating shares (Series 31) are calculated quarterly and based on the 3-month T-bill rate. Because of the declining rate environment, the Series 31 shares trade for less than the Series 30 shares. However, the Series 30 and Series 31 shares can be converted into one another at the option of the holder. Therefore, you could theoretically purchase Series 31 (floating rate) shares today, collect floating dividend payments in the meantime and convert them into Series 30 (rate reset) shares at the Series 30 redemption date in 2020 (at which time the bank will likely be redeeming the rate reset shares for reasons already discussed). Depending on the day and where each series is trading (I've monitored for a few days only), this strategy has provided up to a 1.5% annual return advantage over simply purchasing the Series 30 (rate reset) shares. (At the time of this writing, the advantage is ~0.8%, assuming a 0.3% 3-month T-bill rate to maturity.)

The third exception is along the same lines as the second: the BMO.PR.R (Series 17 - floating rate) shares can be converted into the BMO.PR.M (Series 16 - rate reset) shares at the next redemption date in August 2018. By my estimate, purchasing the BMO.PR.R shares and converting them into the BMO.PR.M shares in 2018 provides nearly a 2% annual return advantage.

Conclusion

I believe the bank rate reset preferred shares are the proverbial baby being thrown out with the bathwater. I believe that the new regulatory landscape dictates that these shares will be redeemed prior to 2022, which therefore makes the cash flows known with certainty. Therefore, I believe some of these preferred shares currently offer excellent returns at minimal risk.

Disclosure: I am/we are long BNS.PR.Y, BMO.PR.Q, BMO.PR.R.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article is not to be interpreted as investment advice. You have to decide whether a security fits your investment style and risk tolerance.

I may initiate a position in any of the mentioned securities at any time.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.