PrefBlog

OK, so this is a pretty long series of posts! And I will admit, a lot of the motivation behind these posts is just to get everything clear in my own mind and look at some actual numbers … and some actual prospectus language! It really just counts as background material for an article to be written some day, if I can convince an editor that there is unsatiated demand for articles dealing with bankruptcies of Big 5 Canadian Banks!

There are two more comparitive tables I want to look at:

It is interesting to note that CIBC is now over the 25% limit for Preferreds in Tier 1 Capital (although they can apply the excess to Tier 2 Capital, which is Sub-Debt territory). If anybody needed any more indication that that provided by a quick look at the dividend paid per annum, then this is an indication that they intend to redeem CM.PR.C as soon as possible. Note that the “Issuance” figure for CIBC is a net figure : two issuances (CM.PR.I and the pending one) and one redemption (CM.PR.B).

It is also interesting that Royal has used up about half its available room. Given that their Tier 1 Ratio at year-end significantly lagged the competition, I suspect that there will be more opportunistic issuances in addition to RY.PR.D and RY.PR.E.

It’s hard to guess just what else might happen. Given that the banks like to make an ENORMOUS return on equity (BMO’s 2006 Annual Report states that the target is 17-19%; they achieved 19.2%; largely due, I suspect, to fees paid by me personally) and only have to pay a 4.5% dividend on perps, it would seem that issuing perps is a no-brainer, especially in this environment where one CAN issue perps and consensus is that interest rates are historically low due to excess global capital. But we shall see! It would be nice to get some more TD issues, especially.

In Part 2 of this series, I claimed that Preferred Shares are, at best, pari passu with Innovative Tier 1 Capital. Therefore, to look at the credit quality of the bank preferreds, we have to look at the Equity / Assets ratio, since only common equity is subordinate to prefs. It would be nice if Preferred Shareholders could stick it to the Innovative Tier 1 holders in the events of problems; but it would be nice too if it rained lemonade; we can’t have everything!

The ratios reported in the second table above are important because:

• The Equity / RWA ratio supports preferred shares and Innovative Tier 1 Capital
• The Tier 1 Ratio supports the banks’ subordinated debt, which is included in their Tier 2 Capital
• The Capital Ratio is what supports deposits

If we’re going to bring things like sub-debt and deposits into this discussion, we have to get an idea of what they are! So, sorry, but I’m going to have to do some more quotation here, this time from the Trust Indenture for the TD Bank 4.317% MTNs Due Jan 18, 2016.

The Indenture provides that an Event of Default in respect of this Debenture shall occur only if the Bank becomes insolvent or bankrupt or resolves to wind-up or liquidate or is ordered woundup or liquidated. If an Event of Default has occurred and is continuing, the Trustee may, in its discretion, and shall upon the request of Holders of not less than one-quarter in principal amount of the Debentures, declare the principal of and interest on all outstanding Debentures to be immediately due and payable. There is no right of acceleration in the case of a default in the payment of interest or a default in the performance of any other covenant of the Bank in the Indenture.

…

Unless previously redeemed, purchased for cancellation, converted or exchanged as provided herein, the principal amount of the Debentures shall be due and payable on January 18, 2016.

After Jan. 18, 2011, these notes pay BAs+100bp. The notes have a Canada Call prior to Jan 18, 2011 and a call at par afterwards. The market treats these things as five-year notes and they are currently quoted at 34bp back of the Canada 4%/2010.

As noted by the Alberta Securities Commission

Deposit Notes are deposits issued by a financial institution and are excluded from the definition of “security” pursuant to sub-paragraph 1(ggg)(v)(B) of the Act.

Accordingly, prospectuses are awfully hard to come by, so I can’t do much quoting! I’ll restrict myself to noting that there is a CIBC Deposit Note, for instance, with a coupon of 4.75% maturing December 22, 2014 and quoted at 41bp back of Canadas 5%/2014.

It is difficult to come up with comparitives for the various levels of debt but we can try! Consider:

The terms of the Royal Sub-Debt are similar to those for the TD Sub-Debt quoted above. 

I can’t get a comparitive Deposit Note. At the RBC online rate page, a GIC paying semiannually and due in 7 years, purchased in an amount in excess of $1,000,000, pays … 3.4%. Which is, more or less, 75bp THROUGH Canadas. Anybody who buys one of these is a fool, since a million bucks should be enough to get rates that … maybe aren’t completely wholesale, but will be a point or so better than what’s being offered on-line! Which is what I’ve estimated for a deposit note of similar term, based on comparables.

One may quibble about the propriety of quoting the prefs in the above table at a spread to the Canada 2013s. Prefs are generally sold to investors by stating the spread to long Canadas … but I take the view that if it’s OK to trade Tier 1 Debt against the shorter Canadas, then it must be OK to trade the prefs against them, too! 

And one may really quibble about my inclusion of equities in the table! However, they are the end-point of the capital continuum and I’ve estimated an equity risk premium of 380bp based on Richard Guay. Another good number is 400bp, which has been discussed by Campbell, Diamond & Shoven. Stick in any number you like! You can only be proved wrong in the long run, and in the long run we’re all dead anyway.

To be perfectly frank, the relative levels for the market-trading debt don’t make a lot of sense to me.

• Sub-Debt holders aren’t getting much more than Depositors. Despite giving up a whole bunch of credit protection. This just seems wrong.
• Tier 1 Investors are only getting 14bp more than Sub-Debt. As shown in the second table of this post, Equity-to-RWA for Royal is 7.56%, vs. a Tier-1-Ratio of 9.6%. That’s a significant loss of credit protection for the Tier-1 holders, and they don’t seem to be getting paid too much for it.
• Taxable Preferred Shareholders are getting distressed yields for high quality credit. Look at it! They’re getting more now than Tier-1-Debt holders will get if in a distressed situation!
• Tier 1 Holders have better rate protection : in the event that Royal Bank becomes distressed AND inflation rises, we can assume that the BA rate will at least meet inflation and pay 150bp extra. Pref holders do not have this degree of protection. Note, however, that should deflation be the operative word, the link to
  BAs will be greatly regretted.
• Taxable Preferred Shareholders are capturing a lot of the equity risk premium, with better protection than equity holders. Pref shareholders are getting 63% of the credit protection accorded to depositors (ignoring Federal Insurance, figure determined by comparing the Equity-to-RWA and Total-Capital ratios).

The fly in the ointment of this analysis is, as always, inflation. A good bout of inflation will be very harmful to the interests of perpetual preferred shareholders and it never pays to forget that. On the other hand, one shouldn’t let Fear rule Greed too harshly … I suggest that Real-Return-Bonds are an appropriate complement to a perpetual preferred portfolio.

What I find really surprising is the extraordinarily small premium that Canadian bond buyers are demanding for Innovative Tier 1 instruments. I am advised that spreads are wider elsewhere in the world. However, Tier 1 instruments are included in the Index (which was determined by … um … Scotia Capital, a subsidiary of the Bank of Nova Scotia) and there is a tendency in Canada to worship the banks anyway … so, “Why not? says Joe Bank-Employed-Portfolio-Manager. “I can pick up 15bp over sub-debt and still have an index-included bond.”

Innovative Tier 1 Capital may be a good instrument … but I don’t think they’re bonds. It’s only a bond if I can bankrupt the issuer for being a day late and a dollar short! And the more I look at them, the less convinced I am that they pay enough of a premium to be worth the chunk of equity-risk that is being taken.

Sub-Debt is bonds. The indenture contains the words “due and payable”. I like the words “due and payable”, they give me a warm fuzzy feeling. When I don’t hear them, I want more money than just straight fixed-income returns.

Perpetual Fixed Rate Preferreds aren’t bonds either, but they pick up a big chunk of the equity-risk-premium while retaining a great many bond-like features. One must be wary of inflation and adjust the remainder of one’s fixed income portfolio accordingly – but represent a great deal for taxable investors at today’s prices.

Update 2007-02-06: Added some commentary for the first table; corrected a typo in the last bulletted list.

Update 2007-02-07: With respect to inflation and the perpetual holding of prefs vs. Innovative Tier 1 (I wish there was a better word for this. Hybrids? I know some people say hybrids.) … can we use the real/nominal Canada spread as a proxy for requirements? I’ll have to think about this a little more … but the prefs pay 4.50% and distressed hybrids will pay Inflation + Real BAs + 150bp … I don’t think anybody will be all that happy about holding either security in a distress scenario, but this series is all about choosing between them.

Update 2007-02-07-A: In this post, I have expressed some surprise that the spread on Hybrids to Sub-Debt is so narrow. However, in Hold your Hybrids (RBC Capital Markets, November 10, 2006), Altaf Nanji takes the view that a spread of 15bp to sub-debt is just fine. It takes two to make a market!

Next Generation Hybrid Securities (Wall Street Lawyer, May 2006) provides a good overview of US practice.

Moodys has announced that as a result of comments received on their RFC Rating Preferred Stock and Hybrid Securities,

that, except for hybrid securities with meaningful mandatory deferral triggers, all preferred stock and hybrid securities will continue to be rated according to existing notching guidelines with no rating distinction made among cumulative, non-cash cumulative and non-cumulative obligations.

Update 2007-02-14: I really should link to Preferreds & Tier 1 Capital (Part 2), just to facilitate navigation.