Royal Bank of Canada has announced:

the applicable dividend rates for its Non-Viability Contingent Capital (NVCC) Non-Cumulative 5-Year Rate Reset First Preferred Shares, Series AZ (the “Series AZ shares”) and NVCC Non-Cumulative Floating Rate First Preferred Shares, Series BA (the “Series BA shares”).With respect to any Series AZ shares that remain outstanding after May 24, 2019, holders of the Series AZ shares will be entitled to receive quarterly fixed rate non-cumulative preferential cash dividends, as and when declared by the Board of Directors of Royal Bank of Canada, subject to the provisions of the Bank Act (Canada).

The dividend rate for the 5-year period from and including May 24, 2019 to, but excluding, May 24, 2024 will be 3.70%for Series AZ shares, being equal to the 5-Year Government of Canada bond yield determined as of April 24, 2019 plus 2.21%, as determined in accordance with the terms of the Series AZ shares.

…

Beneficial owners of Series AZ shares who wish to exercise their conversion rights should instruct their broker or other nominee to exercise such rights on or prior to the deadline for notice of intention to convert, which is 5:00 p.m. (EST) on May 9, 2019.Inquiries should be directed to Shareholder Relations Officer, Shirley Boudreau, at 416-955-7806.

RY.PR.Z is a NVCC-compliant FixedReset, 4.00%+221, that commenced trading 2014-1-30 after being announced 2014-1-21. The extension was announced 2019-4-12. This issue is tracked by HIMIPref™ and is assigned to the FixedReset-Discount subindex.

The most logical way to analyze the question of whether or not to convert is through the theory of Preferred Pairs, for which a calculator is available. Briefly, a Strong Pair is defined as a pair of securities that can be interconverted in the future (e.g., RY.PR.Z and the FloatingReset that will exist if enough holders convert). Since they will be interconvertible on this future date, it may be assumed that they will be priced identically on this date (if they aren’t then holders will simply convert en masse to the higher-priced issue). And since they will be priced identically on a given date in the future, any current difference in price must be offset by expectations of an equal and opposite value of dividends to be received in the interim. And since the dividend rate on one element of the pair is both fixed and known, the implied average rate of the other, floating rate, instrument can be determined. Finally, we say, we may compare these average rates and take a view regarding the actual future course of that rate relative to the implied rate, which will provide us with guidance on which element of the pair is likely to outperform the other until the next interconversion date, at which time the process will be repeated.

We can show the break-even rates for each FixedReset / FloatingReset Strong Pair graphically by plotting the implied average 3-month bill rate against the next Exchange Date (which is the date to which the average will be calculated).

The market has lost its fleeting enthusiasm for floating rate product; the implied rates until the next interconversion are below the current 3-month bill rate as the averages for investment-grade and junk issues are at +0.70% and +1.48%, respectively. Whatever might be the result of the next few Bank of Canada overnight rate decisions, I suggest that it is unlikely that the average rate over the next five years will be lower than current – but if you disagree, of course, you may interpret the data any way you like.

Since credit quality of each element of the pair is equal to the other element, it should not make any difference whether the pair examined is investment-grade or junk, although we might expect greater variation of implied rates between junk issues on grounds of lower liquidity, and this is just what we see.

If we plug in the current bid price of the RY.PR.Z FixedReset, we may construct the following table showing consistent prices for its soon-may-be-issued FloatingReset counterpart given a variety of Implied Breakeven yields consistent with issues currently trading:

Estimate of FloatingReset (received in exchange for RY.PR.Z) Trading Price In Current Conditions |
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Assumed FloatingReset Price if Implied Bill is equal to |
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FixedReset | Bid Price | Spread | 1.50% | 1.00% | 0.50% |

RY.PR.Z | 18.36 | 221bp | 18.37 | 17.86 | 17.36 |

Based on current market conditions, I suggest that the FloatingResets that will result from conversion are likely to trade below the price of their FixedReset counterparts, RY.PR.Z. Therefore, it seems likely that I will recommend that holders of RY.PR.Z continue to hold the issue and not to convert, but I will wait until it’s closer to the May 9 notification deadline before making a final pronouncement. I will note that once the FloatingResets commence trading (if, in fact, they do) it may be a good trade to swap the FixedReset for the FloatingReset in the market once both elements of each pair are trading and you can – presumably, according to this analysis – do it with a reasonably good take-out in price, rather than doing it through the company on a 1:1 basis. But that, of course, will depend on the prices at that time and your forecast for the path of policy rates over the next five years. There are no guarantees – my recommendation is based on the assumption that current market conditions with respect to the pairs will continue until the FloatingResets commence trading and that the relative pricing of the two new pairs will reflect these conditions.

Hi James,

I asked you some time ago a question about the comparison table, but I do not think my question was very clear so I will try again. For Floating Reset why do you consider the rate “1.50%”, “1.00%”, and “0.50%” when the current rate is 1.685%. Why do you not compare the fixed reset with the floating reset considering the 3 month GOC T-bill being, lets say, “1.50%”, “1.75%”, and “2.00%”. We know already the 3 month GOC rate is greater than the 5 years bond yield (1.685% vs 1.49%). The 3 months rate could increase or decrease in the future, but no one knows the future. I would think that choosing a floating reset is more about assuming risks. Also since

a lot of fixed resets are in the ETF portfolios and the managers follow the market I do not think that we will see a conversion soon.

Thank you,

For Floating Reset why do you consider the rate “1.50%”, “1.00%”, and “0.50%” when the current rate is 1.685%.Because the market is pricing FloatingResets such that the implied break-even rate is 0.70% for investment grade and 1.48% for junk.

Anybody who wants a FloatingReset can – mostly – do better by buying one on the secondary market, rather than converting.

I have not looked at all pairs, but it seems their price is about the same though the dividend is higher for the FloatingResets:

-SLF.PR.G/SLF.PR.J the price is $14.98/$15.00 and the dividend is 3.797%/5.134%

-BRF.PR.A/BRF.PR.B the price is $15.70/$15.76 and the dividend is 5.339%/6.63%

What am I missing?

SLF.PR.G pays 2.275% of $25.00 par until the Exchange Date.

SLF.PR.J pays 3-month bills + 141bp until the Exchange Date.

On the Exchange Date, the prices will be the same.

At present the prices are about the same, call them equal.

Therefore, Capital Gains or Losses will be about the same from now until the Exchange Date. Therefore, the only thing you need to worry about is the interim dividends.

For SLF.PR.J to pay more than SLF.PR.G, the average bill rate needs to be more than 2.275% – 141bp = 0.865%. This is the break-even bill rate.

RY.PR.J will reset at 3.70%. Its FloatingReset Counterpart will pay three month bills + 221bp.

Prices are equal now and will be equal at the next Exchange Date. Therefore, the only thing you need to worry about is the interim dividends.

For RY.PR.?, the FloatingReset, to pay more than RY.PR.J, the average bill rate needs to be more than 3.70% – 221bp = 149bp.

Clearly, it is better to have the FloatingReset part of the SLF pair than it is to have the FloatingReset part of the RY pair.

Therefore, we expect the price of the FloatingReset part of the RY pair to go down (relative to RY.PR.Z), because of the Law of One Price. (Alternatively, the price of SLF.PR.J could go up relative to SLF.PR.G. It comes to the same thing).

Or you could just ask yourself: why do I believe the break-even rate will be different for the RY pair than for the SLF pair?

All this is an application of the theory of Preferred Pairs, for which a calculator is available. I suggest you re-read the article and play around with the calculator.

The 3 month bond yield, which today is 1.68, is already greater than 3.70% – 221bp = 149bp and the RY.PR.?, the FloatingReset, will already pay more than RY.PR.Z, the FixedReset. We do not know how long the 3 month bond yield will be at this level, but this is another story.

Thank you,

PS:

-If I understand correctly the calculator says the same thing: if the FixedReset price is the same with the FloatingReset price the “3 Mo CTB” needs to be 1.49%. As today the 3 month bond yield is 1.68%

-Considering the 3 month bond yield is 1.68 the FloatingReset Price should be at $18.51 and the FixedReset at 18.32 in order for them to be equivalent