Thread by @CadPrefs

Everyone has been talking about Limited Recourse Capital Note (LRCN) are changing the preferred share market, with a rising tide lifts all boats. Here is a thread explaining our thoughts.

The first thing to know is institutional and corporate bond investors are willing to sit in the same spot in the capital stack of a bank as a preferred share... but do it for less return. The reason is the preferred share market is illiquid for larger investors.

Retail investors get to pick up extra yield which larger players cannot. We compare the tax-equivalent spread on bank rate reset preferred shares by grossing up the dividend by 1.3 times to capture the dividend tax credit.

With the tax-equivalent yield, we can see the additional illiquidity spread retail investors are collecting over institutional investors.

Not all bank preferred shares will be called. But many investors don't realize that. They are piling into the LRCN replacement trade. It is important to remember that only half of AT1 capital can be LRCN.

And LRCNs can only replace preferred shares that are more expensive to the issuer than the LRCN. Looking at the LRCN issues from the Big 5 banks the average back-end spread is 392BPs, but we need to adjust for the fact that the LRCN is taxable.

Reducing the spread from taxes to 310BPs allows us to determine which rate reset preferred shares will be called and replaced with LRCN capital. With 52 bank rate reset preferred shares only 22 can be called and replaced with LRCN capital.

But investors have pushed up all of the bank rate reset preferred shares. Our model shows that bank rate reset preferred shares that we expected to be called are pricing in a 5-year yield of 0.37%, and the ones we do not expect to be called are pricing in a 0.74% 5-year yield.

The average back-end spread from the group of bank rate reset preferred shares that will not be called is 250BPs. For this group to be called the LRCN issue cost would need to be 3.53%, and seeing how only RBC can issue an LRCN at 4% we don't expect this group to be replaced.

The bank rate resets that will not be called have an expected return of -24.7% in the current interest rate environment. If they reset today the average new yield would be 3.4%, not a group we would recommend investing in.

One thing being overlooked by the market is how a rising tide lifts all boats... ie the 'rest' of the preferred share market. With fewer bank preferred shares on the market, the preferred share index will need to be rebalanced from 37% banks to 26% banks.

The rebalancing of the index will push more fund flows into other sectors of the preferred share market.

We expect 2021 to be a big year for LRCN replacement issues, which will create what we call artificial flow within the preferred share market.

We can predict what ETFs and preferred share funds will do with their new cash since they won't be giving it back to the unitholders because then fee revenue decreases.

The redemption cash received by the ETFs and preferred share funds will need to be redeployed into the preferred share market, which is what we call artificial flow. In 2021 we expect there to be $1B in artificial flow within the preferred share market.

The last time the preferred share market saw over $1B inflow was 2017.

Excluding banks, the rest of the rate reset preferred share market is cheap, pricing in a 5-year yield of 0.04%. With almost 60% of non-bank rate reset preferred shares trading below their roll yield value.

The roll yield value is the value of a rate reset preferred share if the 5-year yield is 0 for the life of the preferred share. Happy hunting everyone!!!