· A new type of debt offered by RBC may drastically change the Canadian preferred share market – it powered strong gains after knowledge of it was made public

· The debt security acts like a preferred, but is being labelled as debt security which creates tax advantages for the issuer (NOT investors)

· These securities are for institutional buyers only, which could redirect interest into the Canadian pref market (scarcity)

· This could have strong implications for the preferred market, potentially leading other banks to effectively replace preferred shares, as they redeem at par value, which would be very beneficial to current pref holders, as the asset class has yet to fully recovered

· High-quality preferred shares remain a very attractive way to generate safe income with inflation adjustments; the value dislocation in the asset is about to get institutional validation

RBC just completed a major round of raising funds through a new type of AT1 debt exclusively to institutions. The issuance was expected to push north of $1-billion and indeed did so, topping out at $1.75-billion, indicating very strong demand. It’s a 60-year bond issue with coupon resets every five years at the government yield plus a premium based on credit spreads. It makes existing bank preferred shares look dirt cheap.

A few twists: this new issue is not available for retail investors. It’s also being called a debt issuance and not a preferred share, which means RBC is getting better tax treatment on it. But the credit quality, long maturity and coupon resets effectively make it a preferred issue. More than $1-billion in orders from institutions provides validation of our long-held view that the Canadian preferred market is undervalued.

There’s more reason for bullishness from this. As banks start to issue more of this new type of debt, existing preferred shares become scarcer because retail investors can’t buy these new instruments. More importantly, because of the tax implications for the issuers, it’s a cheaper form of financing. CFOs may start exercising redemption privileges on existing preferred shares at $25 par value to replace with this new AT1 debt.

The Canadian preferred share market is still dislocated. It won’t last forever, and this institutional validation is likely to even speed up the process. It’s possible that as much as 20% of the Canadian preferred share market may disappear in the next coupon reset cycle, just based on bank preferreds that are 250bps spread and wider.

— Sandy Liang, portfolio manager of Purpose Canadian Preferred Share Fund

All data sourced from Bloomberg unless otherwise noted. By the numbers displays total returns for the month of May, 2020.

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