Low interest rates and emergence of Limited Recourse Capital Notes are changing the market, says portfolio manager
Investors need to re-think their preference for preferred shares and could even end up better off as a result, according to one portfolio manager.
Andy Kochar is head of credit at AGF Investments and said that, while preferred shares have long been a go-to for Canadian investors seeking yield, the market could shrink because of structural changes taking place. He believes this may lead to a re-think of the various other income-generating options that can help anchor a well-rounded portfolio.
Kochar said that “rate resets” face significant challenges moving forward. Firstly, because they have performed poorly due to stubbornly low interest rates and, secondly and more importantly, because there is a long-held desire among bank and life insurance company treasurers to find an alternative structure for the purposes of raising capital more efficiently. These firms, incidentally, make up about 50% of the entire “pref” market.
Kochar said: “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.”
With all these issues, the portfolio manager said there was little surprise that a replacement structure to preferred shares was recently issued, with more issuance of its kind expected in the future. Limited Recourse Capital Notes (LRCN) clearly target institutional investors. They 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. This differs from preferred shares, obviously, where dividends are paid by the issuer out of after-tax income resulting in a dividend tax credit for the investor.
Kochar said that while it’s 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.
He explained: “Bank and insurance prefs represent about 50% of the rate reset market currently and about $12 billion of that is 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.”
This does not paint a pretty picture for preferred shares or for retail investors who may have become overly dependent on them to generate income in their portfolios. What can they do to fill the void.
Kochar said the key, as always, is diversification and 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.
He said: “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.”