New Notes Take On Preferred Shares?

Ruth Saldanha: Recently RBC issued $1 billion of new limited recourse capital notes called LRCNs. This is a new type of fixed income product that may compete with the preferred share market. There is a sense that several banks could eventually redeem their preferred shares and instead issue LRCNs. What are these products and what does it mean for the preferred share market? Robert Colangelo, Senior Vice President of Credit Ratings at DBRS Morningstar, is here today to discuss this.

Robert, thank you so much for being here today.

Robert Colangelo: Thanks for having me, Ruth.

Saldanha: First, what are Limited Recourse Capital Notes? How do they work?

Colangelo: Yeah. So, these are hybrid capital instruments that OSFI has approved to be eligible under the additional Tier 1 capital buffers that the banks need to build up. And they can only be issued to institutional investors. These securities would form part of the nonviable contingent capital that all of the domestic stability the large banks are trying to build as a part of the bail-in regime that came into play a couple of years ago. Typically, these securities do have a longer-dated maturity, and in the case of RBC, it's a 60-year maturity. And they can be called every five years and the coupon does reset every five years as well after the initial period. So, these would certainly be issued in addition with – in the case of RBC, they did issue some perpetual non-preferred shares as well that were being held in a limited recourse trust that were for the benefit of the holders of the LRCNs. And so, they would rank just as equally with other deeply subordinated indebtedness of the bank.

Saldanha: How will RBC's issue work in particular?

Colangelo: Yeah. So, similar to what I just described, what they did is they issued the LRCNs. They also issued these nonviable contingent capital noncumulative five-year fixed rate preferred shares Series BQ that are being held in this limited recourse trust for the benefit of the LRCN holders. So, what would happen in the case that if RBC missed a debt payment on the LRCNs, then the holders of those securities would have the right to those – recourse to those preferred shares that are being held in that trust based on the proportion of its share of ownership in the LRCNs. And then, subsequent to that if there was a trigger event where RBC were to go nonviable, then those preferred shares would actually convert into common equity to recapitalize the bank as a part of the bail-in regime in Canada.

Saldanha: Do you think more Canadian banks are likely to follow suit and issue LRCNs?

Colangelo: Yeah, I mean, it's – it obviously would depend on the size of the – how well received these are in the market and based on RBC's pricing it seems that there is some strong investor demand. Because I think they actually raised $1.75 billion of these LRCNs which is set to close on July 28. So, basically, I think that that is certainly a higher amount that they've raised as compared to preferred shares which typically are to retail investors and they typically would only raise in the range of $200 million to $300 million. So, this issuance is almost 8 times that amount that they could raise with preferred shares. And even the coupon at 4.5% seems to be very cost-effective for RBC. And so, I think, based on that and the fact that the interest payment is deductible from an RBC perspective through earnings, it makes it very – the adjusted tax cost on these securities is very effective. And then, also, any future issuances of these securities could potentially appeal to investors outside of Canada because there is no withholding tax to foreign investors for holding these as well. Now, albeit, the RBC issuance was no registered in the U.S. but was registered outside of Canada as well.

Saldanha: Finally, are these a better product than preferred shares? What are some of the risks both from the bank's perspective and for the investors?

Colangelo: Well, we think that these will actually augment the bank's issuances of preferred shares rather than replace them for a couple of reasons. Firstly, the LRCNs can only be issued to institutional investors whereas the preferred shares are, as I said, sold to retail investors. So, each one of those securities does appeal to a different investor base. And then, secondly, the banks are capped on the amount of LRCN securities that they can hold, have outstanding and this cap is set at 0.75% of risk-weighted assets. So, that actually equates to 50% of their additional Tier 1 capital buffer. So, the banks can't become over-reliant on LRCNs and probably have to issue a mix of preferred shares and LRCN securities going forward.

Saldanha: What are some of the risks associated with LRCNs?

Colangelo: Well, I mean, I think they certainly appeal to institutional investor base versus the retail investor base. So, they are not necessarily a better product or have different risks. In fact, when we assign the rating to the LRCNs, we did rate it at equal to RBC's intrinsic assessment less four notches, which is typical or consistent with DBRS Morningstar's standard notching for capital instruments that have contingent risks and it's rated at the same level as the bank's NVCC preferred shares which albeit is on a different scale, but they effectively equate to the same. So, in essence, we feel that both have the same rating and have the same risks effectively. Our view is that obviously the risk to the investors is just with the contingent risks that are identified. So, if there is a trigger event, then they would be holding common equity as opposed to these either the LRCNs or the preferred shares. And so, effectively, that just helps recapitalize the bank if there is that trigger event and the bank is deemed as nonviable.

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

Colangelo: Thank you, Ruth.

Saldanha: For Morningstar, I'm Ruth Saldanha.