Bankers in the United States looking for innovative ways to raise capital would be wise to pay attention to what banks north of the border are up to.
Since the start of 2008, Canadian banks have raised some $17 billion in fresh capital through a new preferred share structure known colloquially as "rate-reset prefs."
The structure, created by a team of investment bankers and attorneys, was a response to a common challenge: how to create a user-friendly equity security that would be recognized by regulators as Tier 1 capital, would not be dilutive to existing shareholders, and would be cost-effective to the issuer.
Officially they are called "perpetual, noncumulative, fixed/floating, preset five-year rate reset, preferred shares," Today, 70 percent of new preferred share issued in Canada are in the form of "rate-reset prefs."
As the name suggests, rate-reset preferred shares allow an issuer to reset a dividend yield every five years. Investors can choose to convert their fixed-rate preferred shares to a floating rate, at the same yield-premium over a benchmark Government of Canada bond.
This differs from the past in one fundamental way-previously, when an issuer would offer preferred shares for sale, it would set the dividend rate at the time of marketing and closing the offering. If the market dividend rate moved up, the issuer would leave the relatively low-cost shares outstanding. If the market dividend rates were to fall, the issuer would redeem the relatively high-cost shares and refinance itself at the new lower market rate. The investor then faced the risk of changes in the market dividend rate or yield in the ensuing years.
With rate-reset prefs, issuers are much less likely to redeem the shares. They would only have an incentive to do so if the issuer's risk profile had improved enough over the past five years, so they could take advantage of a lower yield premium over the benchmark bond. Therefore, investors are not exposed to the same risk of changes in the fixed-income market. The result is a win-win both issuers and investors. It's also worth noting that recent events in Basel confirmed the Tier 1 eligibility of rate-reset prefs.
The bottom line: Investors in Canada have hungered for these shares because they present an attractive risk-return profile, and they are easily understood compared with other new fixed-income products.
