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Bank of Nova Scotia, Toronto-Dominion Bank and Bank of Montreal have bucked conventional wisdom and decided to keep three of the very first series of rate-reset shares that are nearing their anniversary.MARK BLINCH/Reuters

Canada's banks must soon decide what to do with the deluge of preferred shares that are about to come due.

In the heat of the financial crisis, the banks sold a slew of so-called rate-reset preferred shares. By the end of 2014, about $7-billion worth of these securities will hit their five-year anniversary – dates at which the banks must decide if they want to keep them in the market, or cough up the cash to redeem them.

Five years ago, this decision seemed simple. When the banks first issued these shares, the crisis was kicking into high gear and the Big Six, as well as other financial institutions, needed fresh capital to serve as cushions against any losses. Because common equity is always an expensive source of capital, they turned to these newly created rate-reset shares.

At the time, it was assumed that once the financial system was on much steadier ground, as it is now, the banks would simply redeem the shares, rather than continue paying the 6 per cent dividend yields that investors demanded.

The decision seemed even easier to make when the Basel Committee on Banking Supervision determined a few years ago that these preferred shares would not count toward its revised Tier 1 capital ratio calculation. If the banks couldn't include these shares in their capital buffer, why bother keeping them on their balance sheet?

Yet three banks – Bank of Nova Scotia, Toronto-Dominion Bank and Bank of Montreal – have bucked the conventional wisdom and decided to keep three of the very first series of rate-reset shares that reached their anniversary.

That means investors must choose between two different types of dividend payments for the next five years, when the banks will have the option to redeem again – either a fixed dividend set at a spread over the five-year Government of Canada bond, or a floating rate dividend that fluctuates with the yield on three-month Treasury Bills.

While the decision of the three banks may be surprising, John Nagel at Desjardins Securities said there's no reason to assume banks will keep all of these shares in the market. Mr. Nagel was one of the key members of the team that worked with the Office of the Superintendent of Financial Institutions to structure these shares and make sure they complied with OSFI's tough standards around capital treatment.

For these three banks, Mr. Nagel said it makes sense to keep the early issues because they were sold before the market really blew up. That means they weren't structured with big spreads over government bonds. The Bank of Nova Scotia issue, which was first sold in March, 2008, requires a dividend yield of only 2.05 per cent over government bonds.

And while the new Basel rules state that these shares can't count toward Tier 1 capital, the rule will be phased in over a 10-year period. Starting this past January, the value of these shares that can be counted toward Tier 1 capital falls by 10 per cent each year, meaning 90 per cent of their value counts this year, and 80 per cent next year. The banks, then, can still use them to buy time before replacing the capital.

For later issues – those first sold in the hectic days of late 2008 and early 2009 – the dividend spreads above Canada bonds are simply too high for the banks to keep them around. Some of these shares pay dividends at more than 4 per cent above five-year Canada bonds, which means that if they were rolled over today, they would yield north of 6 per cent. For that reason, Mr. Nagel said investors are buying the shares with big spreads, treating them like short-term money market securities that mature in one year or less. In other words, investors expect to get their money back when the banks redeem the shares, and will collect a juicy yield until then.

(Tim Kiladze is a Globe and Mail banking reporter.)

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