Critchley of Financial Post: Fixed-Resets Good!

Barry Critchley of the Financial Post had a piece in today’s Financial Post – Ruggins a Master of Tier 1, in which he comes out in favour of the currently fashionable fixed-reset structure:

If a bank was interested in raising Tier 1 capital and wanted to demonstrate that it was investor friendly, a useful starting point would be to call Len Ruggins, the former executive in charge of capital market funding for BCE and Bell Canada.

During his career, Ruggins raised more than $30-billion of capital, or more than any other non-bank executive in the country. Ruggins, now based in Calgary, had a rule: Don’t bag investors. He interpreted that rule by opting never to issue fixedrate perpetual preferred shares. The reason: They aren’t in the best interests of investors. Instead, they serve the interests of issuers that have all the power to let the prefs stay out there forever — and forever is a long time.

In five years when the so-called subsequent fixed-rate period comes around, investors have a choice: They can opt to receive other fixedrate pref shares that have a yield equal to the rate on five-year Canada bonds plus 205 basis points. In this way, the spread becomes a permanent part of the formula and means investors won’t be harmed by any improvement in Scotiabank’s credit spread over the period. If in five years the yield on Canada bonds is above 2.95%, then investors will receive a higher nominal yield; if the yield is lower, investors will receive a lower nominal yield.

In five years, investors have another choice: They can opt to convert to non-cumulative floating-rate preferred shares. The floating-rate pref shares will pay a dividend equal to the three-month T-bill rate plus 2.05%. However, the floating-rate pref is available only if there is a minimum-sized float.

From Scotia’s perspective, the issue was attractive: It gets Tier 1 capital, given that OSFI, the federal regulator, signed off on the transaction, and it still gets to control most of the shots. As well, the structure allowed the bank to raise more capital — at a lower yield — than a traditional perpetual.

Since Scotia’s deal — on which it’s understood Desjardins Securities played a key structuring role — Fortis raised $200-million via a similar offering.

The Fortis new issue and the Scotia new issue have both been previously discussed.

There are some critical flaws in Mr. Critchley’s analysis:

  • Credit risk has a high degree of importance in fixed income investing … particularly with instruments that won’t ever just run off the books. Due to the risk that bad times may come, investors must increase their expected returns in the event that good times continue.
  • Contrary to If in five years the yield on Canada bonds is above 2.95%, then investors will receive a higher nominal yield, there is no assurance that the bonds will not be called at such a time.
  • There is an inherent contradiction within As well, the structure allowed the bank to raise more capital — at a lower yield — than a traditional perpetual. Issuers and investors are at war with each other. A lower yield – good for the issuer – can be justified only to the extent that risk is transferred … in this case, there is some show of transferring interest rate risk. The fact that these issues are callable in five years at par means that the transfer inherent in these prefs is minimal.

Incidentally … the portfolio strategy of one major dealer advises investors to retain cash for investment in new, “defensive”, fixed-reset issues … so I suspect that there are a lot of deals in the pipeline waiting for an opportune moment.

4 Responses to “Critchley of Financial Post: Fixed-Resets Good!”

  1. […] There is a possibility that a rush of new issues of this type is in the pipeline, as has been noted previously. Should the asset class become important, the fixed-resets from Fortis and from Scotia […]

  2. […] None for me thanks! I’ve commented on this structure previously and don’t like the fact that I’m expected to take perpetual credit risk for 5-year rates. It’s just another attempt to finance long with pretend-short-term paper … which was a major contributing factor to the Credit Crunch. However … some people like ‘em! […]

  3. […] Critchley of the Financial Post has written another column, reiterating his earlier praise of the structure. In the current column, BNS Offers Investors Better Deal he states: But in five […]

  4. […] Critchley of Financial Post: Fixed-Resets Good! […]

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