has downgraded its credit rating on the Preferred Shares issued by Financial 15 Split Corp. (the Company) to Pfd-4 (high) from Pfd-3. The rating downgrade is based on the deterioration in downside protection to 42.1% as of January 15, 2024, from 46.1% as of January 31, 2023, the increase in the Preferred Shares’ distribution rate to 9.25% annually on the Preferred Share’s redemption value of $10.0 for the fiscal year beginning December 1, 2023, from 7.50% annually for the fiscal year beginning December 1, 2022, a decline in the dividend coverage ratio to 0.37 times (x), a projected grind of 8.9% per year over the remaining term and unhedged foreign currency exposure.
The Company invests in a portfolio (the Portfolio) consisting primarily of common shares of 15 financial services companies made up of Canadian and U.S. issuers as follows: Bank of America Corporation; Bank of Montreal; The Bank of Nova Scotia; Canadian Imperial Bank of Commerce; CI Financial Corp.; Citigroup Inc.; The Goldman Sachs Group, Inc.; Great-West Lifeco Inc.; JPMorgan Chase & Co.; Manulife Financial Corporation; National Bank of Canada; Royal Bank of Canada; Sun Life Financial Inc.; The Toronto-Dominion Bank; and Wells Fargo & Company. The Company may invest up to 15% of the Net Asset Value (NAV) in securities of issuers other than the core 15, and no more than 10% of the NAV may be invested in any single issuer. As of August 31, 2023, only 1.2% of the Portfolio was also invested in the other two companies, namely Fifth Third Bancorp and AGF Management, and 23.6% was held in cash.
A portion of the Company’s Portfolio is exposed to currency risk because it includes securities denominated in U.S. dollars (USD), while the NAV of the Company is expressed in Canadian dollars. The Company has not entered into currency-hedging contracts for the USD portion of the Portfolio, although the Company may use derivatives for hedging purposes. As of August 31, 2023, 34.4% of the Portfolio was invested in USD-denominated assets.
The Company established an at-the-market (ATM) equity program in November 2021, which was effective until December 22, 2023. Upon termination, the Company has renewed the ATM Program to issue Preferred Shares and Class A Shares to the public from time to time at the Company’s discretion, effective until January 20, 2026, unless terminated prior to such date by the Company. The maximum gross proceeds from the issuance of the shares will be $400.0 million. During the period ended May 31, 2023, 5,691,210 Preferred Shares were sold through the ATM Program at an average selling price of $9.72 per Preferred Share, raising gross proceeds worth $55.3 million. During the same period, 5,806,000 Class A Shares were sold through the ATM Program at an average selling price of $9.23 per Class A Share, raising gross proceeds worth $53.6 million.
The Company’s termination date is December 1, 2025. At maturity, the holders of the Preferred Shares will be entitled to the value of the Company, up to the face amount of the Preferred Shares, in priority to the holders of the Class A Shares. Holders of the Class A Shares will receive the remaining value of the Company. The termination date can be extended for additional terms of five years at the Company’s discretion, but shareholders are provided with a special retraction right in connection with such extension.
The Preferred Shares distribution rate is set by the board of directors annually and subject to a minimum of 5.5% until 2025. Holders of the Preferred Shares used to receive cumulative monthly cash dividends at a rate of 6.75% annually until November 30, 2022. With effect from December 1, 2022, this rate was increased to 7.50% annually and further to 9.25% annually with effect from December 1, 2023. Holders of the Class A Shares are currently receiving monthly distributions of $0.1257 per share, equivalent to 10.1% per annum on the issue price of $15.0. No distributions will be paid to the Class A Shares if the NAV per unit falls below $15.0. The NAV per unit remained above $15.0 during 2023, and distributions to the Class A Shares were regularly paid out.
As of January 15, 2024, the asset coverage ratio is at 1.7x. The downside protection available to holders of the Preferred Shares was 42.1%. Without giving consideration to capital appreciation potential or any source of income other than the dividends earned by the Portfolio, the current Preferred Share distributions together with the distributions on the Class A Shares will create a projected grind on the NAV of the Portfolio of approximately 8.9% per year for the remaining term of the Preferred Shares. To supplement the Portfolio income, the Company may engage in covered call options and put option writing on all or a portion of the shares held in the Portfolio.
Recent Updates/Treasury Offerings
(i) On May 25, 2023
The Company’s announced that the Toronto Stock Exchange (the “TSX”) has accepted its notice of intention to make a Normal Course Issuer Bid (the “NCIB”) to purchase its Preferred Shares and Class A Shares through the facilities of the TSX and/or alternative Canadian trading systems. The NCIB commences on May 29, 2023 and terminates on May 28, 2024. Pursuant to the NCIB, the Company proposes to purchase, from time to time, if it is considered advisable, up to 4,007,080 Preferred Shares and 4,017,102 Class A Shares.
(ii) On September 21, 2023
The Company announced that the Preferred Shares distribution rate for the fiscal year beginning December 1, 2023 will be $9.25% per annum, in comparison to previous rate of 7.50% on the initial issue price of $10.0.
(iii) On December 20, 2023
The Company renewed its ATM Program pursuant to a prospectus supplement dated December 20, 2023 to the Company’s short form base shelf prospectus dated December 19, 2023. The ATM Program allows the Company to issue Class A Shares and Preferred Shares to the public from time to time, at the Company’s discretion. The maximum gross proceeds from the issuance of the shares will be $400.0 million and the ATM Program will be effective until January 20, 2026, unless terminated prior to such date by the Company.
The main constraints to the rating are the following:
(1) Volatility in stock prices along with changes in the dividend policies of the underlying issuers may result in significant reductions in the Preferred Shares’ dividend coverage or downside protection from time to time.
(2) A Preferred Shares’ dividend coverage that is less than one time.
(3) Reliance on the manager to generate a high yield, through methods such as option writing, on the investment portfolio to meet distributions and other expenses without having to liquidate portfolio securities.
(4) The monthly cash distributions to holders of the Class A Shares which create grind on the Portfolio.
(5) The concentration of the Portfolio in one industry.
(6) The unhedged portion of the USD-denominated Portfolio that exposes the Portfolio to foreign currency
risk.
The affected issue is FTN.PR.A.
DBRS places emphasis on the grind in the portfolio due to the Capital Unit dividends, but the mitigating factor is that these dividends will be (and have been in the past) halted if the NAVPU falls below $15. It is not clear how much account has been taken of this. However, the 9.5% yield on the preferreds means that, as they say, the preferred share dividend coverage ratio is less than one time.
