Overlooking apparent risks, investors snap up new bank financings

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Despite the risks presented by conversion clauses in recent bank financings, Canadian investors continue to buy these institutions' new issues in droves.

To comply with new global regulations intended to reinforce banks' stability in a crisis, Canada's largest lenders have started issuing new types of debt and preferred shares. They come with clauses that allows them to be converted to common equity in the event of a financial emergency – forcing the holders, rather than taxpayers, to shoulder the burden of recapitalizing a failing bank.

After the financial crisis, regulators worried the banks could deplete their capital cushions quickly when the market turns ugly. As a safeguard, the regulators now require banks to insert a conversion clause into certain bonds and preferred shares, in order for them to count toward banks' capital requirements.

Initially, there were concerns that investors would balk at the changes, because bonds and preferred shares are typically repaid first in the event of bankruptcy. If the securities are converted into common shares, their holders lose this privilege.

However, since the start of the year, multiple banks have issued non-viability contingent convertible (NVCC) debt, and $4.5-billion worth of these preferred shares have also been sold.

Royal Bank of Canada was the first financial institution to test the market in January, and the $500-million initial preferred share issue blew out ultimately. In total, 12 different issues have now been sold in just 10 months.

The first NVCC issue, which again came from RBC, received some criticism from bond investors because they felt they weren't given adequate time to dig into the bonds' features.

Since then, though, more issues have come to market, and investors have scooped them up.

The strong interest in these issues appears to suggest investors do not care about the conversion clauses, but other factors may also explain the heavy demand.

One, retail investors are typically the biggest buyers of preferred shares, and they may not fully grasp the extra risk they are taking on. While many retail advisers will take pains to explain these securities to their clients, others simply will be enticed by the commissions paid from getting their clients to invest in these issues.

Also, the debt market has its own peculiar dynamics. Before the NVCC issues came out, Canadian bond investors had been starved of new product – largely because the banks went quiet as they figured out the best way to structure the new bonds. Once the new issues were launched, investors jumped at the chance to buy.