Big Canadian companies forced to rethink ways to raise funds

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A sudden change of heart from retail investors is making financing decisions much tougher for Canada's biggest companies.

Until recently, retail investors were happy to buy new issues of rate reset preferred shares from companies such as Royal Bank of Canada, TransCanada Corp. and Husky Energy Inc.

Such a heavy appetite for the product made it easy for these issuers to raise cash. In 2014, $14-billion worth of these securities were gobbled up.

But lately, retail investors are giving rate reset preferred shares the cold shoulder. Burned by poor performing issues, they are much less willing to buy new offerings of these securities.

It is particularly troubling for Canadian banks, because as of January, 2014, these institutions needed to refinance as much as $20-billion worth of these shares, according to Moody's Investors Service. Many of the preferred shares they issued in the years following the financial crisis no longer comply with global capital rules.

Preferred shares are considered to be safer, more stable investments than common shares, yet some of their prices have plunged. Sun Life Financial Inc. sold $280-million of these securities in 2010 for $25 apiece; today they are trading at $16.15. Fortis Inc. sold $250-million of these shares in 2010 for $25 each; the same securities are now trading for $16.63. If their yields reset today, they would be cut almost in half.

Faced with weaker demand for rate resets, big Canadian companies are being forced to look at different products in order to raise funds.

Three weeks ago, RBC tested the waters by issuing an old-school style of preferred shares, known as 'perpetuals.'

Whereas the coupon, or interest rate, on rate reset preferred shares 'resets' every five years based on a spread over five-year government bonds, perpetuals are much more like bonds with fixed rates.

RBC's experiment caught many people by surprise. Six months ago, rate reset preferred shares were in such heavy demand that Toronto-Dominion Bank set out to raise $300-million and the deal size was quickly increased to $500-million. Such upsizes, as they are known, were common for sales of these securities. Yet by March, RBC tried to sell $300-million of the same type of shares and the deal was met with such weak demand that it had to be repriced – a rare occurrence for preferreds. Hence the switch to perpetuals. RBC's latest experiment is also rather ironic. One of the reasons rate reset preferred shares were created in 2009 was to replace the perpetual structure, because many of its securities were trading poorly. Now the old-school structure is coming back in style because some rate resets are experiencing rough market performance.

This doesn't mean rate reset shares can't still be sold. Husky Energy issued $150-million of its own earlier this month. However, more companies are experimenting with the perpetual structure because of concerns there isn't enough investor demand for all of the regular preferred share issues to sell rate resets. After RBC tested the waters, Loblaw Cos. Ltd. sold $225-million worth of perpetual preferred shares.

There is also a chance that investors could switch back to favouring rate resets just as quickly as they put them in the corner. "If we suddenly have a rising rate environment and these [securities] start to reset at a more realistic coupon, you could see retail demand come back," said Brad Hardie, an investment banker who covers financial institutions at BMO Nesbitt Burns.

The chief problem for rate resets is that bond yields have plummeted for the past five years. When many of these securities were first sold in 2009 and 2010, the expectation was that their issuers would redeem them when they were about to reset in five years' time. The shares are priced with a fixed spread over five-year Government of Canada bonds, so rising rates make them more expensive for the issuer.

However, many of the shares were sold with a thin spread over government bonds – some as low as 128 basis points. If a series of Sun Life Financial shares were to reset today, they would only pay a yield of 2.25 per cent, and investors have fled.

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Underperforming rate reset preferreds

TransCanada Series 3

Issue date: March 2010

Issue price: $25

Initial yield: 4.00 per cent

Current price: $14.82

Spread over five-year gov't bond: 128 basis points

If reset today, yield would be: 2.25 per cent

Fortis Series H

Issue date: January 2010

Issue price: $25

Initial yield: 4.25 per cent

Current price: $16.63

Spread over five-year gov't bond: 145 basis points

If reset today, yield would be: 2.42 per cent

Sun-Life Financial Series 8R

Issue date: May 2010

Issue price: $25

Initial yield: 4.35 per cent

Current price: $16.15

Spread over five-year gov't bond: 141 basis points

If reset today, yield would be: 2.38 per cent

Source: Bloomberg and public filings