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Royal Bank of Canada bolstered its balance sheet this week by selling $1.75-billion of a new, tax-efficient security, opening the door to what’s expected to be a wave of similar offerings from rival Canadian banks.

The country’s largest bank sold what is known as a “limited recourse capital note,” or LRCN, that is seen as debt by institutional investors but will be treated similar to equity by federal regulators for the purpose of calculating RBC’s all-important capital requirements.

RBC’s launch of LRCNs is shaking up the domestic preferred share market, with some investors expecting the new notes to take the place of new preferred share offerings.

In practice, LRCNs are a combination of two securities. RBC will issue 60-year non-callable debt securities to investors. Alongside this, the bank will issue preferred shares that will be held in a kind of escrow account. In the unlikely event that RBC defaults on its debt payments, investors will be handed the preferred shares.

“You can think about the preferred shares as collateral for the notes,” said Timothy Hughes, a partner with the law firm Osler, Hoskin & Harcourt LLP, who worked with RBC to develop the structure. “They only become activated if they get handed over.”

Canada’s banking regulator, the Office of the Superintendent of Financial Institutions, approved the innovative structure last week. RBC spent years developing the securities and wasted little time launching a deal, working with J.P. Morgan Securities Canada Inc. The LRCN offering was snapped up by 105 institutional investors, with demand more than twice the supply of notes.

RBC’s LRCNs pay 4.5-per-cent interest for the next five years, then the payout resets every five years at a set premium above the interest rate on Government of Canada debt. Each RBC note has a face value of $1,000 and matures in 60 years. The product can only be sold to institutional investors.

From RBC’s point of view, the LRCN is far more tax efficient than preferred shares, as the interest payments on the note can be deducted from the bank’s income for tax purposes, while dividends on preferred shares are not tax deductible. RBC paid $3-billion of tax last year, when it earned $12.9-billion in income.

“These terms make LRCNs very attractive funding instruments for financial issuers,” said Toronto-based Brompton Group in a report. The fund manager said these securities are “the holy grail for financial issuers: tax-deductible equity financing.”

Other OSFI-regulated banks and insurance companies are expected to issue LRCNs. In a report, National Bank Financial said the Big Six banks alone could issue $16.7-billion of LRCNs.

The treasury departments at other Canadian banks are closely following the RBC deal, said Sean St. John, head of fixed income at National Bank Financial Markets. The structure is attractive for several reasons. RBC managed to price the deal around 75 basis points, or 0.75 per cent, below where similar preferred shares are trading. It also managed to attract a huge amount of interest from institutional investors.

The preferred share market would be hard-pressed to “digest” a $1.75-billion offering, Mr. St. John said, “whereas the institutional debt market has the capacity to do that and can actually accommodate all this size.”

“I think people are moving fairly quickly to get lined up and see what capacity they have to issue [these notes], and are looking keenly at the market right now,” he said.

OSFI’s approval of LRCNs and RBC’s subsequent offering appear to have reverberated through Canadian preferred share markets. Starting last week, investors bid up the price of preferred shares, apparently in the expectation that banks will use the proceeds from LRCN issuance to redeem outstanding preferred shares.

Investors, however, may be “overly hopeful” on this front, according to the report from Brompton Group. “Preferred share issuance may be on pause for now as financial issuers focus on issuing LRCNs to institutional and accredited investors with lower market-based demand for income than retail preferred share investors, but this event should not represent the end for Canadian preferred shares or preferred share issuance,” the note said.

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