Category: Market Action

DBRS finalized the RBC LRCN rating today:

DBRS, Inc. (DBRS Morningstar) assigned a final rating of A (low) with a Stable trend to Royal Bank of Canada’s (RBC or the Bank) NVCC Additional Tier 1 (AT1) Limited Recourse Capital Notes (Capital Notes). DBRS Morningstar assigned the rating equal to the Bank’s Intrinsic Assessment of AA less four rating notches, which is consistent with DBRS Morningstar’s standard notching for capital instruments with contingent risks and its ratings for the Bank’s NVCC Preferred Shares. This is one notch below the rating of RBC’s NVCC Subordinated Debt.

On July 28, 2020, RBC issued $1.75 billion of Capital Notes that mature on November 24, 2080, and will have an initial five-year fixed rate of 4.5%. DBRS Morningstar notes that the Capital Notes were granted Tier 1 capital treatment by the Office of the Superintendent of Financial Institutions.

RATING DRIVERS
Given RBC’s high rating level and the current economic environment, an upgrade of the ratings is unlikely. Ratings would be downgraded if there is a prolonged adverse impact of the Coronavirus Disease (COVID-19) pandemic resulting in a sustained deterioration in asset quality, especially due to deficiencies in risk management. Additionally, a sustained weakening of profitability metrics would also result in a downgrade of ratings.

There was something of a peculiar Staff Note published by the Bank of Canada today, Will exchange-traded funds shape the future of bond dealing?, by Rohan Arora, Jean-Sébastien Fontaine, Corey Garriott and Guillaume Ouellet Leblanc:

The rise of exchange-traded funds (ETFs) makes JIT possible in bond markets. ETFs are securities traded on an exchange, just like stocks, that entitle the bearer to a share in a pool of assets (such as stocks or bonds). For example, a fixed-income ETF might entitle its bearers to a share of a pool of 100 bonds. We find that a dealer can use bond ETFs as a warehouse to meet investor demand to buy and sell bonds. Similar to a car maker using JIT production, the dealer can reduce its inventories of “parts” and order them from its “suppliers” through a JIT approach.

Admittedly, ETFs make up only a small share of the Canadian asset management industry. Our analysis shows that ETFs in Canada are not yet used as warehouses to a large extent. But the practice is growing in the United States. These changes to the way dealers handle bonds can transform the market by:

• improving prices
• reducing the costs of large trades
• making it easier for issuers themselves to borrow funds

…
ETF warehousing is when dealers use bond ETFs to deposit and withdraw—or push and pull—bonds instead of using inventory. Figure 1 compares the ETF warehousing model with the traditional bond dealer model:

• Typically, a dealer distributes bonds by keeping them in inventory until it finds a client that wants them. If the dealer does not hold bond inventory, it cannot fulfill client orders promptly. As a result, it might lose a trade to another dealer.
• The ETF warehousing model works differently. Instead of holding individual bonds in inventory, a dealer relies on a pool of bonds held within an ETF—an outside warehouse. Using a JIT approach, the dealer could pull bonds from the ETF to fulfill client orders or push bonds acquired from clients to the ETF.

…
The 2019 US Securities and Exchange Commission ETF rule, which allows all ETFs to conduct custom exchanges, could make ETF warehousing more common. In addition, bond ETFs may become more willing to engage in custom exchanges as they grow their assets under management

The SEC rule is explained in part with:

Rule 6c-11 will provide certain exemptions from the Act and also impose certain conditions. The conditions include the following:

• Transparency. Under rule 6c-11, an ETF will be required to provide daily portfolio transparency on its website.
• Custom basket policies and procedures. An ETF relying on rule 6c-11 will be permitted to use baskets that do not reflect a pro-rata representation of the fund’s portfolio or that differ from the initial basket used in transactions on the same business day (“custom baskets”) if the ETF adopts written policies and procedures setting forth detailed parameters for the construction and acceptance of custom baskets that are in the best interests of the ETF and its shareholders. The rule also will require an ETF to comply with certain recordkeeping requirements.
• Website disclosure. The rule will require an ETF to disclose certain information on its website, including historical information regarding premiums and discounts and bid-ask spread information. These disclosures are intended to inform investors about the costs of investing in ETFs and the efficiency of an ETF’s arbitrage process.

So what I’m not entirely clear on about all this is: why ETFs? The only reason I can think of is because ETFs are so big … Blackrock Canada has seven corporate bond funds on offer, with a total of about 4.6-billion under management. That’s a lot of inventory and makes it very likely that Blackrock could meet an order for just about anything in any kind of reasonable size.

But there are plenty of other corporate bond portfolios under management in Canada. The Canada Pension Plan, for instance, has $40-billion in credit investments (see the 2020 Annual Report, page 14) or possibly 50.8-billion (see page 67). Why aren’t they doing this, using either extant staff or hiring an ‘overlay’ manager with a mandate to be market neutral, borrowing their short positions from the main fund?

Teachers’ has $93-billion in Fixed Income (see page 11 of the 2019 Annual Report. Where are they at?

When I was with Greydanus Boeckh so many years ago, I used to explain our basic strategy as providing month-to-month liquidity (in Canada bonds) to the dealers, who provided day-to-day liquidity to the market; much to the consternation of the smart guys who would explain to me that it’s impossible to outperform a market. I have predicted – so far unsuccessfully, I think – that US restrictions on proprietary trading by the Big Banks would bring an increase in market making by hedge funds.

Liquidity provision is fundamental to the market and there’s a lot of money to be made. I simply don’t understand why this ‘warehousing’ (I always used a car dealership analogy) concept is considered such a new idea.

Brookfield Residential Properties Inc., a wholly owned subsidiary of Brookfield Asset Management, has been downgraded to B by S&P:

• Calgary, Canada-based Brookfield Residential Properties Inc.’s profitability has suffered from diminished demand due to the coronavirus pandemic, which accelerated a downward trend that began in 2019.
• We are lowering our issuer credit rating on Brookfield Residential Properties Inc. (BRPI) to ‘B’ from ‘B+’ to reflect its higher leverage.
• At the same time, we are lowering our issue-level rating on the company’s senior unsecured notes to ‘B+’ from ‘BB-‘. Our ‘2’ recovery rating remains unchanged.
• The negative outlook reflects our expectation that BRPI’s liquidity may become constrained if it is unable to extend or renegotiate its $675 million revolving credit facility before its March 2021 maturity.

S&P has downgraded Bombardier to CCC:

• Bombardier Inc. recently announced that it had secured a commitment for a new secured term loan facility for up to US$1 billion due 2023.
• We believe the intended use of the new facility is to provide Bombardier with additional liquidity to operate its business through the COVID-19 pandemic as the company works to close previously announced divestitures.
• Based on the secured claim of the proposed term loan on certain aviation inventory and related accounts receivable, we estimate lower recovery prospects for the company’s unsecured creditors in our hypothetical default scenario.
• As a result, S&P Global Ratings lowered its issue-level rating on Bombardier’s unsecured notes to ‘CCC’ from ‘CCC+’. We revised the recovery rating to ‘5’ from ‘4’.
• All other ratings on the company are unchanged, including S&P Global Ratings’ ‘CCC+’ issuer credit rating (ICR).

The preferreds, which they downgraded to CC in March, are unaffected.

Canadian inflation has surged!

Canada’s inflation rate surged in June, as the re-opening of more of the economy following COVID-19 shutdowns pushed consumer prices back into positive territory.

Statistics Canada reported Wednesday that consumer price index (CPI) was up 0.7 per cent year over year, a sharp reversal from the declines of 0.4 per cent in May and 0.2 per cent in April. It was the biggest increase in the annual inflation rate in nine years.
…
The index surged 0.8 per cent from May to June, as the easing of pandemic-containment restrictions triggered rebounds in prices for consumer goods, which had slumped amid a dearth in demand during the lockdowns. The biggest contributor was gasoline, which jumped 10.5 per cent from May. Excluding energy prices, CPI was up 0.4 per cent month-over-month, and 1.2 per cent on an annual basis.

Among the leading price gains in the month were clothing and footwear, as stores in many provinces re-opened. Beef prices also surged, reflecting COVID-related shutdowns and production slowdowns at several meat processing plants.

The much discussed RBC LRCNs, given credit for a nice little pop in the market last week, have been priced:

Royal Bank of Canada bolstered its balance sheet this week by selling $1.75-billion of a new, tax-efficient security, opening the door to what’s expected to be a wave of similar offerings from rival Canadian banks.

The country’s largest bank sold what is known as a “limited recourse capital note,” or LRCN, that is seen as debt by institutional investors but will be treated similar to equity by federal regulators for the purpose of calculating RBC’s all-important capital requirements.

RBC’s launch of LRCNs is shaking up the domestic preferred share market, with some investors expecting the new notes to take the place of new preferred share offerings.
…
The LRCN offering was snapped up by 105 institutional investors, with demand more than twice the supply of notes.

RBC’s LRCNs pay 4.5-per-cent interest for the next five years, then the payout resets every five years at a set premium above the interest rate on Government of Canada debt. Each RBC note has a face value of $1,000 and matures in 60 years. The product can only be sold to institutional investors.

From RBC’s point of view, the LRCN is far more tax efficient than preferred shares, as the interest payments on the note can be deducted from the bank’s income for tax purposes, while dividends on preferred shares are not tax deductible.
…
The structure is attractive for several reasons. RBC managed to price the deal around 75 basis points, or 0.75 per cent, below where similar preferred shares are trading. It also managed to attract a huge amount of interest from institutional investors.

The official announcement from RBC reads:

Royal Bank of Canada (RY on TSX and NYSE) today announced the offering of $1.75 billion of non-viability contingent capital (NVCC) Additional Tier 1 (AT1) Limited Recourse Capital Notes, Series 1 (the “LRCNs”).

The LRCNs will bear interest at a rate of 4.50 per cent annually, payable semi-annually, for the initial period ending November 24, 2025. Thereafter, the interest rate on the LRCNs will reset every five years at a rate equal to the prevailing 5-year Government of Canada Yield plus 4.137 per cent. The LRCNs will mature on November 24, 2080. The expected closing date of the offering is July 28, 2020. RBC Capital Markets is acting as lead agent on the issue.

Concurrently with the issuance of the LRCNs, the bank will issue NVCC Non-Cumulative 5-Year Fixed Rate Reset First Preferred Shares, Series BQ (“Preferred Shares Series BQ”) to be held by Computershare Trust Company of Canada as trustee for a newly formed trust (the “Limited Recourse Trust”). In case of non-payment of interest on or principal of the LRCNs when due, the recourse of each LRCN holder will be limited to that holder’s proportionate share of the Limited Recourse Trust’s assets, which will consist of Preferred Shares Series BQ except in limited circumstances.

The bank may redeem the LRCNs during the period from October 24 to and including November 24, commencing in 2025 and every five years thereafter, only upon the redemption by the bank of the Preferred Shares Series BQ held in the Limited Recourse Trust, in accordance with the terms of such shares and with the prior written approval of the Superintendent of Financial Institutions (Canada), in whole on not less than 15 nor more than 60 days’ prior notice.

Net proceeds from this transaction will be used for general business purposes.

The prospectus for this issue is not yet available but there is a term-sheet on SEDAR. I am not permitted to link directly to this document, because the Canadian Securities Administrators think you’re too dumb to read it, but search for “Royal Bank of Canada Jul 21 2020 22:55:26 ET Marketing materials – English PDF 198 K”. Anyway, the part I’m interested in is just what “Limited Recourse” means:

Limited Recourse: If (i) there is non-payment by the Bank of the principal amount of the Notes, together with any accrued and unpaid interest, on the Maturity Date, (ii) a Failed Coupon Payment Date occurs, (iii) the Bank does not pay the Redemption Price in connection with a redemption of the Notes in cash, (iv) an event of default under the Notes occurs or (v) a Trigger Event (defined below) occurs (each such event, a “Recourse Event”), the recourse of each Noteholder will be limited to that Noteholder’s proportionate share of the assets (the “Trust Assets”) held by a third party trustee (the “LRT Trustee”) in respect of the Notes in a newly formed trust (the “Limited Recourse Trust”). The LRT Trustee may hold assets in the Limited Recourse Trust in respect of more than one series of limited recourse capital notes, in which case the assets (including the Bank’s preferred shares) for each such series will be held separate from the assets for other series. Initially, Computershare Trust Company of Canada will act both as the LRT Trustee and the Indenture Trustee (defined below).

Initially, at the time of issuance of the Notes, the Trust Assets will consist of the Bank’s Non-Cumulative 5-Year Fixed Rate Reset First Preferred Shares, Series BQ (“Preferred Shares”) issued at an issue price of C$1,000 per Preferred Share. The Trust Assets may alternatively consist of (i) Preferred Shares, (ii) cash if the Preferred Shares are redeemed for cash by the Bank with the prior written approval of the Superintendent, (iii) Common Shares upon the conversion of the Preferred Shares into Common Shares as a result of a Trigger Event or (iv) any combination thereof, depending on the circumstances.

The number of Preferred Shares issued at the time of issuance of the Notes will be equal to the total principal amount of the Notes divided by C$1,000. If the Trust Assets consist of Preferred Shares at the time a Recourse Event occurs, the Bank will deliver to each Noteholder one Preferred Share for each C$1,000 principal amount of Notes held, which shall be applied to the payment of the principal amount of the Notes, and such delivery of Preferred Shares will be each Noteholder’s sole remedy against the Bank for repayment of the principal amount of the Notes and any accrued but unpaid interest thereon then due and payable.

Upon the occurrence of a Recourse Event that is a Trigger Event, the Bank will deliver to each Noteholder that Noteholder’s proportionate share of the Common Shares issued in connection with the Trigger Event. The number of Common Shares issuable in connection with the Trigger Event will be calculated based on a Share Value (as defined below in the Preferred Share Final Term Sheet) of C$1,000. Such Common Shares shall be applied to the payment of the principal amount of the Notes, and such delivery of Common Shares will be each Noteholder’s sole remedy against the Bank for repayment of the principal amount of the Notes and any accrued but unpaid interest thereon then due and payable. See “NVCC Automatic Conversion” below.

The receipt by a Noteholder of its proportionate share of the Trust Assets upon the occurrence of a Recourse Event shall exhaust the remedies of the Noteholders under the Notes. If a Noteholder does not receive its proportionate share of the Trust Assets under such circumstances, the sole remedy of the Noteholder for any claims against the Bank shall be limited to a claim for the delivery of such Trust Assets.

In case of any shortfall resulting from the value of the Trust Assets being less than the principal amount of and any accrued and unpaid interest on the Notes, all losses arising from such shortfall shall be borne by the Noteholders.

All claims of Noteholders against the Bank under the Notes will be extinguished upon receipt of the Trust Assets.

So anyway, what happens in sixty years when the maturity date of the notes arrives but market conditions are such that the underlying preferred shares may be reasonably expected to trade below par? The choices available to the bank will be to
(a) redeem the preferreds anyway, or
(b) distribute the preferreds to the noteholders.

Seeing that option (b) will be viewed by the market as a default, it seems to me that that’s a helluva incentive to redeem the preferreds. And Tier 1 Capital is not supposed to have any incentive to redeem (that’s why banks and insurers can’t offer minimum rate guarantees on their marketable preferreds). I can only wonder at how the skilled logicians at OSFI have managed to square that circle.

The term sheet for the preferreds, attached to the term sheet for the LRCNs states:

Concurrently with or upon the maturity of the Notes, with the prior written approval of the Superintendent, the Bank may redeem all but not less than all of the outstanding Preferred Shares by the payment of an amount in cash for each share redeemed of C$1,000 and apply, or cause the LRT Trustee to apply, the proceeds of such redemption towards the repayment of the aggregate principal amount of and any accrued and unpaid interest on the Notes.

To add to my discussion of July 15, July 16 and July 17, I will quote from an eMail I sent recently:

It’s entirely possible that LRCNs will rise in price in the future and narrow their spreads; and it also seems quite likely that future supply of bank – and probably insurance – issues will be constrained.

But there’s more going on than just that. Supply has been virtually nil since late May 2019 (when TD & CM came out with new issues) and not much of a positive effect has been observed (to put it mildly!). I will also note that supply was massive during the great FixedReset issuance frenzy (and of pretty poor quality to boot) and prices just continued to rise until one day they didn’t.

I keep reading that limited supply will raise prices dramatically, but it all seems just a little desperate to me. I haven’t seen one single supply-and-demand curves graph, for instance. Given the overwhelming influence of rate-anticipation on the preferred market for the past ten years, I’m not even sure how one would go about creating one!

It is also important that there are limits on the issuance of LRCNs – … RBC has about $4.2-billion of issuance capacity. But as of YE 2019, they had about $5.7-billion in preferreds outstanding (see http://prefblog.com/?p=41139 ), so they couldn’t redeem them all with LRCN proceeds even if they wanted to. I suspect that they will use the proceeds of one note to redeem all their outstanding NVCC non-compliant issues and then simply issue LRCNs when they need capital.

Bank treasurers will also want to keep the preferred share market reasonably healthy simply to keep a financing avenue available.

LRCNs may will trade at a lower yield than preferreds, but I’m highly uncertain about the potential for preferreds to gain in price as a direct result, particularly if the LRCNs are issued in foreign currencies. Who is going to sell LRCNs to buy preferreds? Especially if they’re of a different currency? Canadian institutions will be writing off the tax benefits of preferreds; Canadian retail investors won’t be allowed to buy LRCNs in the first place; all investors will have to deal with the scanty liquidity available in the Canadian preferred share market; price volatility is enormous in the preferred share market, for those who care about such things; and there are other technical issues, such as investment mandates that specify that only bonds (or things that look a little bit like bonds) can be purchased and just what exactly can be pledged to Central Banks in times of stress.

I believe there will be some effect. I believe that the existence (and the potential for further issuance) of LRCNs is somewhat beneficial for the market. But I believe that the overwhelmingly most influential factor in preferred share market levels at this time is government interest rate anticipation – and I don’t think the market will be forecasting sharply higher rates any time soon.

I will also note that it is my understanding (unconfirmed, because FTSE Russell wants me to register – and presumably pay – just to read their damned index announcements) that the issue will not be included in the FTSE Canada Universe Bond Index or other FTSE Canada fixed-rate indexes. I’m very pleased that OSFI’s prior attempts to influence the indices and hoodwink investors have been beaten back.

PerpetualDiscounts now yield 5.68%, equivalent to 7.38% interest at the standard equivalency factor of 1.3x. Long corporates now yield 2.91%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has widened slightly (and perhaps spuriously) to 445bp from the 440bp reported July 15. We are now back at the pre-2020 record of 445bp briefly touched in 2008.

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TXPR closed at 560.76, down 0.87% on the day. Volume today was 3.17-million, third-highest of the past thirty days, behind July 15 and July 16.

CPD closed at 11.27, down 0.62% on the day. Volume was 120,524, above the median of the past 30 trading days.

ZPR closed at 8.92, down 0.89% on the day. Volume of 606,262 was fourth-highest of the past 30 trading days.

Five-year Canada yields were up 3bp to 0.37% today.

A modest pull-back after two days of sharp increases.

I don’t have any particular insights into why the rally has paused, halted, or commenced a reverse (take your pick of the correct description). I will opine, though, that the LRCNs discussed on July 15 and July 16 are not really a big deal, although their existence is modestly favourable to the preferred share market.

If we look at the RBC Annual Report for 2007, we see (page 77 of the PDF) they had 2,344-million in preferreds outstanding and 3,494-million in Trust Capital Securities, their version of AT1 Capital at the time. Move forward to their Annual Report for 2019 we find 5,707-million in preferred shares (page 194 of the PDF) and no Trust Capital Securities at all (page 193 of the PDF).

In addition, we remember that the LRCNs can be included in Tier 1 Capital to a maximum amount of one-half the total amount of allowable AT1 capital (which includes preferred shares), so preferred shares of some kind will always be around, since even now they’re a lot cheaper from a treasury perspective than issuing common.

So I say, yes, it’s good for the preferred share market that LRCNs are allowed. Reduction of supply and all that. But all in all, we’re really just returning to the status quo ante. It remains to be seen whether spreads also return to the status quo ante.

Update: Every time I look at this, I get a bit more dubious about the beneficial effects of the nascent LRCN market on the preferred share market.

Just for fun, I decided to look up the statistics on one of the RBC TruCS – the TruCS Series 2013 was the first one I found. It was redeemed 2013-12-31 and was issued via a prospectus dated 2005-10-20. This prospectus is on SEDAR, so the Canadian Securities Administrators will not permit me to link to it directly, because investor-scum should not be looking at official regulatory documents, but you can find it via a search for “RBC Capital Trust Oct 21 2005 10:24:12 ET Final long form prospectus – English PDF 172 K”.

The indicated distribution on these things was:

Series 2015 entitles the holder to receive the
Indicated Distribution of: (i) $24.35 on the last day of June and December of each year commencing June 30, 2006 to and including December 31, 2015 provided that such date is a Regular Distribution Date, representing a
per annum yield of 4.87% of the initial issue price; and (ii) on Regular Distribution Dates following December 31, 2015, an amount equal to the result obtained by multiplying $1,000 by one half of the sum of the Bankers’ Acceptance Rate in effect during the Distribution Period immediately preceding the Relevant Distribution Date plus 150 basis points.

So we would call it 4.87% for the initial period, and BAs+150bp after the 2015 pretend-maturity. Other terms are pretty much as I remember them – all these AT1 issues were basically preferred shares wearing a false mustache so they could pass as bonds.

All very well and good, but spreads, man, spreads! What were preferreds doing around then? Well, as it happens, the HIMI PerpetualDiscount subindex on 2005-10-20 was trading to yield an average of … 4.90%. There were only seven issues included in it at the time, CM.PR.H, GWO.PR.H, MFC.PR.B, POW.PR.D, PWF.PR.K, SLF.PR.A and SLF.PR.B.

So in other words, the AT1 back then was basically trading even-yield pre-tax with PerpetualDiscounts. Just like, more or less, the USD AT1 recently issued by Scotiabank, as discussed on July 6, in that it was more or less even-yield, pre-tax, with a notional Canadian FixedReset preferred share, despite being in a different currency with a base-rate based on Treasuries, not Canadas.

So I get a bit more perplexed every day about how come the market popped.

Of course, all of this is based on a single data-point, of the RBC TruCS-2015. If anybody wants to help me out by looking up prospectuses and terms for all or some of the pre-2008 AT1 bank issues, I’ll put that together with the relevant preferred share yields and publish it all, with credit to anybody helping. We can’t wait for Bay Street analysts to do this! They’re busy – no sooner do they get to work than they have to go have lunch with a client and then it’s nap time … the days are just packed!

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TXPR closed at 565.70, up 4.09% on the day. Volume today was 5.93-million, by far the highest of the past thirty days, well ahead of second-highest July 15.

CPD closed at 11.34, up 4.13% on the day. Volume was 378,294, the highest of the past 30 trading days and far ahead of second-highest July 15.

ZPR closed at 9.00, up 5.26% on the day. Volume of 2,290,330 was by far the highest of the past 30 trading days, well ahead of second-place July 15.

Five-year Canada yields were unchanged at 0.34% today.

The Canadian preferred share market rocketted upward today, thrown into a tizzy by the Royal Bank’s LRCN issue discussed yesterday. Multiple dealers offered commentary opining that the existence of this option could decrease the volume of bank new issuance in the future and also held out the possibility that redemption of extant issues could be financed by this structure.

It is my understanding that the interest paid by the Special Purpose Vehicle (that owns the preferred shares and issues the AT1 60-year notes) is tax deductible to the bank, since, according to one dealer:

Thanks to a ruling from OSFI this morning, the coupon payments on this instrument will be tax-deducible to the bank (unlike to a preferred share dividend). For years since Basel III came about this was not possible because CRA required a security have a maturity date to receive be tax deductible, while OSFI required a security not have a maturity date to receive capital treatment. Now that OSFI has softened its stance, this instrument represents a more tax-efficient way for banks to raise Additional Tier 1 capital.

It is not clear to me how the tax benefits of the underlying preferred shares are recovered by the bank, it may be that the dividends simply disappear on consolidation.

One reader writes in and asks:

did you notice 2 references in footnotes to Lifecos in the OSFI Ruling on new AT1 you posted on your site? I find that interesting.

Why talk about Lifecos for this new AT1 product which is all about NVCC unless NVCC is around the corner?

To put these footnotes in context, here’s a version of the OSFI ruling published yesterday:

OSFI concluded that the LRCN structure meets all of the criteria to be recognized as Additional Tier 1 regulatory capital by the Bank and other FRFIs [Footnote reads “If issued, the LRCNs may be recognized as Tier 1 Capital Instruments other than Common Shares in the case of life insurers or Category B capital in the case of property & casualty insurers or mortgage insurers.”]
…
LRCN issuances will be subject to a cap of 0.75% of RWA [Footnote reads “OSFI will develop equivalent limitations for insurers in due course.”]

And finally, here’s the S&P rating announcement for the issue:

S&P Global Ratings said today it assigned its ‘BBB’ issue-level rating to Royal Bank of Canada’s (RBC; AA-/Stable/A-1+) Canadian dollar-denominated additional Tier I structure limited recourse capital notes. Under this structure, a trust has been established where the bank is the sole beneficiary. Investors of the notes will have recourse only to the assets held by the trust. At the same time, S&P Global Ratings assigned its ‘BBB’ issue-level rating to the bank’s preferred shares, which will reside in the trust.

In accordance with our criteria for hybrid and other capital instruments, the rating reflects our analysis of the proposed instrument, and our assessment of RBC’s ‘a+’ stand-alone credit profile (SACP).

The ‘BBB’ issue rating is four notches below RBC’s SACP, incorporating:

• A deduction of one notch, the minimum downward notching from the SACP under our criteria for subordinated debt, reflecting contractual subordination;
• A deduction of two additional notches, reflecting that the coupon payments are fully cancellable, at the issuer’s discretion; and
• A deduction of an additional notch to reflect that this subordinated note features a (mandatory) contingent conversion (non-viability contingent capital [NVCC]) trigger. Should a trigger event occur (as defined by the Office of the Superintendent of Financial Institutions’ [OSFI] guideline for Capital Adequacy Requirements), each preferred share held in the limited recourse trust will automatically and immediately be converted, without the holder’s consent, into a number of fully paid and freely tradable common shares of the bank, determined in accordance with a conversion formula.

The following constitute trigger events:

• OSFI advises the bank that it is of the opinion that the bank has ceased, or is about to cease, to be viable and that, after the conversion of all contingent capital instruments and taking into account any other relevant factors, it is reasonably likely that the viability of the bank will be restored or maintained; or
• A federal or provincial government in Canada publicly announces that the bank has accepted or agreed to accept a capital injection, or equivalent support, from the government or a political subdivision or agent or agency without which the bank would have been determined by OSFI to be non-viable.

The notes are rated the same as RBC’s NVCC preferred shares, as we would expect the probability of default of the former to be similar to that of the latter. This is despite the notes ranking ahead of the bank’s preferred shares in an insolvency or wind-up–because this preference is only relevant to loss given default; our ratings focus chiefly on probability of default.

The cancellability of the notes’ coupons, without causing a default or wind-up of the bank, and with no material restriction, represents a degree of loss-absorption capacity. Although RBC has the option to redeem the notes after a certain period, we understand this period will be no less than five years after the date of issuance, and we see no structural incentive to redeem the notes at the first call date–implying a degree of longevity. This combination of features leads us to assess the equity content of these notes as intermediate (as defined in our criteria).

S&P Global Ratings’ ‘BBB’ rating on the bank’s preferred shares, which will reside with the trust, reflects the rating on the bank’s outstanding NVCC preferred shares in accordance with its criteria for hybrid and other capital instruments. Although the notching for this instrument is identical to that on the proposed notes, the distinguishing factors are the risk of regulatory intervention and the deferral risk over the life of the instrument.

To be frank, basing a rally of current proportions on the existence of this structure seems a little extreme to me. Cessation of supply of bank issues doesn’t seem to me, by itself, to be all that big a deal; I suspect that those who are driving the market up so substantially are taking the view that this structure will be used to fund the redemption of extant issues currently trading at around $20.

There are also very clear indications that this structure – or something very similar, that does not mention NVCC – will be accessible to insurance companies, so maybe you can justify this as well.

But what about all the other issuers that are also up substantially? Is this based on lack of bank supply too, on the grounds that a rising tide lifts all boats? Are speculators hypothesizing that if the banks are successful in creating a new market for deeply subordinated 60-year notes, then the other issuers will join in with great enthusiasm, with a resurgent exchange-traded COPrS market?

Or could it be that there has been all kinds of money sitting on the sidelines, aching to get back into the preferred share market and looking for a sign, any sign, that could serve as a trigger for a broad rally?

You won’t catch me speculating (much)!

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TXPR closed at 543.45, up 2.56% on the day. Volume today was 3.66-million, by far the highest of the past thirty days, well ahead of second-highest June 23.

CPD closed at 10.89, up 2.45% on the day. Volume was 157,679, the highest of the past 30 trading days and just ahead of second-highest June 25.

ZPR closed at 8.55, up 3.26% on the day. Volume of 1,247,410 was by far the highest of the past 30 trading days, well ahead of second-place June 30.

Five-year Canada yields were unchanged at 0.37% today.

Other markets did well, attributed largely to a potential coronavirus vaccine:

Canadian and U.S. stocks ended higher on Wednesday, following promising early data for a potential COVID-19 vaccine and a strong quarterly report from Goldman Sachs. It was the highest close for the TSX since March.

Moderna Inc rallied after a small-scale study showed its experimental COVID-19 vaccine produced high levels of virus-killing antibodies.
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A raft of stimulus measures and encouraging economic data have lifted the S&P 500 to about 5% below its record high hit in February.

However, the United States has failed to control the coronavirus and there is a high level of uncertainty over how much the pandemic will affect the economy, Philadelphia Federal Reserve Bank President Patrick Harker said, as a number of U.S. sunbelt states reported a surge in COVID-19 cases recently.

Unofficially, the Dow Jones Industrial Average rose 228.47 points, or 0.86%, to 26,871.06, the S&P 500 gained 29.1 points, or 0.91%, to 3,226.62 and the Nasdaq Composite added 61.92 points, or 0.59%, to 10,550.49.
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In Toronto, the S&P/TSX Composite Index closed up 154.88 points, or 0.97%, at 16,063.33. Most sectors were higher, led by a 3.03% boost in real estate stares. Energy rose 2.11%, financials 1.32%, and telecom 1.41%.

There were no big surprises in the Bank of Canada rate announcement:

The Bank of Canada today maintained its target for the overnight rate at the effective lower bound of ¼ percent. The Bank Rate is correspondingly ½ percent and the deposit rate is ¼ percent. The Bank is also continuing its quantitative easing (QE) program, with large-scale asset purchases of at least $5 billion per week of Government of Canada bonds. The Bank’s short-term liquidity programs announced since March to improve market functioning are having their intended effect and, with reduced market strains, their use has declined. The provincial and corporate bond purchase programs will continue as announced. The Bank stands ready to adjust its programs if market conditions warrant.

While economies are re-opening, the global and Canadian outlook is extremely uncertain, given the unpredictability of the course of the COVID-19 pandemic. Reflecting this, the Bank’s July Monetary Policy Report (MPR) presents a central scenario for global and Canadian growth rather than the usual economic projections. The central scenario is based on assumptions outlined in the MPR, including that there is no widespread second wave of the virus.

After a sharp drop in the first half of 2020, global economic activity is picking up. This return to growth reflects the relaxation of necessary containment measures put in place to slow the spread of the coronavirus, combined with extraordinary fiscal and monetary policy support. As a result, financial conditions have improved. The prices of most commodities, including oil, have risen from very low levels. In the central scenario, the global economy overall shrinks by about 5 percent in 2020 and then grows by around 5 percent on average in 2021 and 2022. The timing and pace of the recovery varies among regions and could be hampered by a resurgence of infections and the limited capacity of some countries to contain the virus or support their economies.

The Canadian economy is starting to recover as it re-opens from the shutdowns needed to limit the virus spread. With economic activity in the second quarter estimated to have been 15 percent below its level at the end of 2019, this is the deepest decline in economic activity since the Great Depression, but considerably less severe than the worst scenarios presented in the April MPR. Decisive and necessary fiscal and monetary policy actions have supported incomes and kept credit flowing, cushioning the fall and laying the foundation for recovery. Since early June, the government has announced additional support programs, and extended others.

There are early signs that the reopening of businesses and pent-up demand are leading to an initial bounce-back in employment and output. In the central scenario, roughly 40 percent of the collapse in the first half of the year is made up in the third quarter. Subsequently, the Bank expects the economy’s recuperation to slow as the pandemic continues to affect confidence and consumer behaviour and as the economy works through structural challenges. As a result, in the central scenario, real GDP declines by 7.8 percent in 2020 and resumes with growth of 5.1 percent in 2021 and 3.7 percent in 2022. The Bank expects economic slack to persist as the recovery in demand lags that of supply, creating significant disinflationary pressures.

CPI inflation is close to zero, pulled down by sharp declines in components such as gasoline and travel services. The Bank’s core measures of inflation have drifted down, although by much less than the CPI, and are now between 1.4 and 1.9 percent. Inflation is expected to remain weak before gradually strengthening toward 2 percent as the drag from low gas prices and other temporary effects dissipates and demand recovers, reducing economic slack.

As the economy moves from reopening to recuperation, it will continue to require extraordinary monetary policy support. The Governing Council will hold the policy interest rate at the effective lower bound until economic slack is absorbed so that the 2 percent inflation target is sustainably achieved. In addition, to reinforce this commitment and keep interest rates low across the yield curve, the Bank is continuing its large-scale asset purchase program at a pace of at least $5 billion per week of Government of Canada bonds. This QE program is making borrowing more affordable for households and businesses and will continue until the recovery is well underway. To support the recovery and achieve the inflation objective, the Bank is prepared to provide further monetary stimulus as needed.

Very diplomatic of them not to mention that a loose fiscal policy is required to back up a loose monetary policy! Of course, those who run this country are well aware that loose monetary policy makes the rich richer, via increases in asset prices, while a loose fiscal policy will generally make the rich poorer eventually, via higher taxes, so there are no prizes for guessing the most likely outcome.

The BoC also published the Monetary Policy Report:

The news conference followed the publication of the bank’s quarterly Monetary Policy Report (MPR) – Mr. Macklem’s first as head of the bank. He succeeded Stephen Poloz just six weeks ago. The bank usually updates its economic forecasts in each MPR, but Mr. Poloz opted against specific projections in April, citing extreme uncertainty at the height of the crisis.
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It estimated that the inflation rate – a key measure for the bank – fell to -0.1 per cent in the second quarter. The bank forecast that even as the economy reopens, inflation would be a thin 0.4 per cent in the third quarter, and just 0.6 per cent for the year as a whole, before picking up modestly to 1.2 per cent in 2021 and 1.7 per cent in 2022.
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But Charles St-Arnaud, chief economist at Alberta Central, the province’s credit-union association, said Mr. Macklem’s call for Canadians to rely on a long period of low rates to finance consumption seemed at odds with the bank’s long-standing concerns about elevated consumer debt.

“I find it interesting that missing from that statement is the risk of pushing already extremely leveraged households and businesses to even more extreme levels,” he said. “It feels a bit like the BoC is somewhat contradicting itself.”

Well, if leveraged households go bankrupt, then the rest of us will have a target to sneer at, which is the whole point of politics. “Why didn’t they just get some money from Daddykins, like we did?”

OSFI has excitedly announced a new way for banks to raise Tier 1 capital:

A Canadian bank is now marketing a new financial instrument called a Limited Recourse Capital Note (LRCN). The bank has sought a ruling from OSFI regarding the regulatory capital treatment of the LRCNs.

OSFI has reviewed the quality of this structure relative to the eligibility criteria set out in Chapter 2 of OSFI’s Capital Adequacy Requirements Guideline, with particular emphasis on economic substance over legal form. We also considered the potential behaviour and impacts of the structure on financial stability, particularly in periods of stress.

OSFI has published a capital ruling that explains OSFI’s considerations in determining that the LRCNs can qualify as Additional Tier 1 regulatory capital by the bank and other FRFIs, subject to certain limitations and disclosure requirements.

Details are pretty much as one would expect:

A Canadian bank (the Bank) proposed to issue the LRCNs to third-party investors. The structure consists of two instruments: (1) deeply subordinated interest-bearing LRCNs with a term to maturity of 60 years issued by the Bank directly to investors; and (2) perpetual, non-cumulative preferred shares issued by the Bank to a special purpose vehicle (SPV) for the benefit of LRCN holders.
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In the event of the non-payment of principal or interest in cash on any interest payment date, upon an event of default [Footnote 2], or at maturity, the sole recourse against the Bank for the claims of LRCN holders will be the delivery of the preferred shares held by the SPV. Upon a non-viability trigger event as described in Chapter 2 of OSFI’s Capital Adequacy Requirements (CAR) Guideline, the LRCNs’ principal, plus accrued and unpaid interest, will become due and payable and, upon non-payment of such principal and interest, LRCN holders will receive common shares of the Bank issued upon conversion of the preferred shares held by the SPV. Redemptions or purchases of the LRCNs or underlying preferred shares by the issuing entity will be subject to prior Superintendent approval.

subject to some limitations:

Limitations on Investor Base
The LRCNs can only be issued to institutional investors.
Limitations on LRCNs’ and Preferred Shares’ Terms and Conditions
LRCNs and preferred shares must have a minimum par or stated value of $1000 and be traded on institutional desks (i.e. not exchange-listed).
The LRCNs must have an initial term to maturity of at least 60 years.
Unless the instrument has been replaced with an instrument of higher capital quality (i.e. CET1-qualifying common shares or retained earnings), the issuer will only be permitted to redeem the LRCNs or preferred shares where the carrying cost of the LRCNs or preferred shares exceeds the cost of replacement capital of equivalent quality (i.e. AT1).
Limit on LRCN Issuances
LRCN issuances will be subject to a cap of 0.75% of RWA [Footnote 7] (i.e. 50% of the AT1 bucket) as measured on the date of issuance.
In calculating this limit, the issuer should compare the aggregate of its outstanding and proposed issuances of LRCNs on the date of issuance to 0.75% of RWA. The limit should consider the issuer’s capital at the last reporting date with adjustments for subsequent transactions including issuances, redemptions, buybacks, and acquisitions.
Disclosure
The disclosure and marketing of the LRCNs to investors must clearly disclose how the LRCNs’ risks are equivalent to the risks of investing in directly issued Tier 1-qualifying Non-Viability Contingent Capital (NVCC) preferred shares.

DBRS has assigned the structure a rating of A(low):

DBRS, Inc. (DBRS Morningstar) assigned a provisional rating of A (low) with a Stable trend to Royal Bank of Canada’s (RBC or the Bank) NVCC Additional Tier 1 (AT1) Limited Recourse Capital Notes (the Capital Notes). DBRS Morningstar assigned the rating equal to the Bank’s Intrinsic Assessment of AA less four rating notches, which is consistent with DBRS Morningstar’s standard notching for capital instruments with contingent risks and its ratings for the Bank’s NVCC Preferred Shares. This is one notch below the rating of RBC’s NVCC Subordinated Debt.

This appears to mean that the banks will be able to issue preferred shares at bond prices, but I’m not sure how the taxes will work – it depends on whether the SPV is consolidated for tax purposes, or if there is some other way of the bank recovering the tax benefit of the preferred share dividends … or even if the preferred shares can pay interest!

PerpetualDiscounts now yield 5.71%, equivalent to 7.42% interest at the standard equivalency factor of 1.3x. Long corporates now yield 3.00%, so the pre-tax interest-equivalent spread (in this context, the “Seniority Spread”) has narrowed to 440bp from the 450bp reported July 8. We are now back below the pre-2020 record of 445bp briefly touched in 2008.