Portfolio manager says Royal Bank's investment bankers are 'modern-day Paul Bunyans' after recent issue
There are bargains to be had in the Canadian preferred share market, with Royal Bank’s investment bankers labelled modern-day Paul Bunyans after its recent AT1 issue.
Geoff Castle, portfolio manager of PenderFund Capital, said the bank’s July move highlighted the value of the market – and views it as “extremely cheap”.
To illustrate the point he compared Weston and Fairfax preferreds to their corporate debt. While Weston perpetual preferred shares that used to be priced to yield the same nominal yield as Weston corporate bonds now pay approximately 5.5%, tax-disadvantaged Weston 2032 bonds yield 3.2%. Meanwhile, Fairfax preferred C’s, a reset series, pay out 7.8% while Fairfax bond yields are in the low 3’s.
“Even assuming resetting at current record low rates, the Fairfax C’s would still be paying out almost three times the after-tax yield as the corporate debt,” Castle added.
The portfolio manager watched with interest when the Royal Bank created its AT1 preferred equity substitute. Looking somewhat like a bond, the AT1 notes were snapped up by fixed-income investors desperate for Canadian fixed coupon issues paying out more than 4%.
Castle explained: “We can understand the CFO of the Royal Bank’s calculus. If you can replace qualifying equity capital, which costs over 5% in after-tax dollars, with similarly qualifying 4.5% AT1 notes, whose pre-tax distributions can be deducted against the bank’s tax bill, that is a significant advantage to the bank.
“But why investors would readily surrender higher after-tax yielding pref shares for lower yielding ‘bond-like’ 4.5% preferred notes is another question altogether.”
He said that, essentially, the bank accessed a cheap pool of capital (the C$ bond market) and is using the proceeds to redeem securities in an expensive pool for issuers (the C$ pref share market).
He said: “The situation to us seems analogous to a case where two nearby lakes exist at different altitudes, say 500 feet and 1000 feet. If you can dig a canal between the two bodies of water, then water will flow from the higher lake to the lower lake, at least until the point at which the water levels equalize.
“Consider Royal Bank’s investment bankers to be modern-day Paul Bunyans, digging a channel that starts to equalize risk-adjusted yields in the bond market with those of the pref share market. The more pref share issues that are called away, the scarcer the existing pref share issues become. And, eventually we believe this cycle will begin the long-overdue process of lowering yields in the pref share market towards more fundamentally appropriate levels. In other words, we like prefs!”
