Canadian Rate Reset Preferreds – Positive developments

You all know by now that I am not a favourite of rate reset preferreds. Extremely poor liquidity and rate reset risk when interest rates are low are major impediments from investing in them.

However, there have been some recent developments in regards to Canadian banks that have altered the preferred share market somewhat. Historically banks have been major issuers of rate reset preferreds as the capital raised could be included as Tier 1. The dividend on these preferreds was not considered interest and thus not deductible by the banks on their tax returns.

Recently, OSFI, the Canadian regulator, has granted approval for a new type of instrument called Limited Recourse Capital Notes (LRCN’S). These notes can be counted as additional Tier 1 capital. In addition while OSFI considers these notes permanent capital, the securities are considered bonds with the interest on them fully tax deductible by the banks. This deductibility of the interest makes them a cheaper way for banks to raise more capital.

Historically banks have been major issuers of rate reset preferreds. This new OSFI ruling is expected to create a potential shortage of new Canadian rate reset preferred issues, thereby lifting market valuations.

Secondly, there now exists a real possibility of many bank rate reset issues of being called and replaced by these new LRCN’S. This will also lift valuations. Fiera Capital expects up to $11 billion of redemptions over the next few years representing almost 17% of the overall preferred share market.

The LRCN’S will only be available to institutional investors as a new issue, but may still be available to retail investors in the secondary market. I assume that the distribution will not be eligible for the dividend tax credit as it is considered interest, but those details are quite hazy at this time. OSFI has not yet granted permission to Canadian non-financial companies to issue them. However these companies can currently issue a hybrid security instead of the preferred.