Rate-reset prefs may be hike hedge

Capital gains, dividend income could ensue

Investors in the year’s first issue of preferred shares by a chartered bank — a $400-million offering by CIBC announced Wednesday — may not have to wait long before they get a read on the merits of their investment.

Next week Stephen Poloz, Bank of Canada governor, is expected to announce a hike in the key lending rate. That’s the view of the chief economists at the chartered banks who have come to that conclusion based on economic data, particularly the central bank’s recently released business outlook survey.

If that happens the expectation would be for interest rates across the spectrum to move up — though they maybe not to the full extent of the rate hike.

Indeed some market rates have already moved up in response to previous rate hikes.

That background brings CIBC’s issue into perspective: the offering of non-viability contingent capital in the form of preferred shares came with a coupon of 4.50 per cent.

That coupon consists of a base rate of 205 basis points (the yield on five-year Canada bonds) and a 245 basis points spread.

That 205-basis-points base may look a little thin next week if the Bank, as expected, hikes its lending rate. And based on recent transactions, the spread may also be a little light.

Consider two recent NVCC deals: last June CIBC raised $800 million at 4.40 per cent at a spread of 338 basis points; while last July TD Bank raised $350 million at a spread of 301 basis points.

While CIBC has its supporters, few would argue it’s of higher quality than TD, meaning it commands a lower premium. Instead, the yields paid on the two recent deals by the two banks show the benefits of market timing. But if CIBC paid the same spread as TD did last July, the yield on its current $400 million issue — which could rise to $450 million if the underwriters exercise the option — would have been 5.06 per cent.

“On the surface the coupon is about right but the spread is low because the yield on five-year Canada bonds has risen substantially over the last few months,” said John Nagel, a Bay Street veteran, who is now an independent consultant on preferred shares.

How substantial? Last July when TD completed its issue, the five-year Canada yield was 149 basis points; Wednesday the yield on the same security was 205 basis points, representing a 37-per-cent jump over the period.

“If lower spreads are acceptable today then perhaps we will see more bank issuance,” said Nagel Wednesday, who is of the view the banks may also follow the lead of Bank of Nova Scotia and issue AT1 notes.

Banks issue those notes, which are NVCC compliant, to investors outside of Canada. Last October, BNS raised US$1.25 billion — for which it paid 4.65 per cent for five years — from a security that is debt but which counts as additional Tier 1 capital.

For those investors who didn’t participate in CIBC’s offering, Nagel has two other suggestions. Firstly, seek out existing rate-reset issues with low initial spreads that are trading below par and whose coupon will be reset in late 2018 and beyond. “There should be some additional capital gains on top of dividend income expected,” he said.

Secondly, for those who don’t want to invest in particular issues, active managers provide a pooled approach. He mentioned three such funds: the Horizons Active Preferred Share ETF, the Dynamic Preferred Yield Class Fund and the Natixis Canadian Preferred Share Fund.