NVCC non-compliant bank preferreds: random thoughts

Caveat: I am not licensed to provide advice. Any of my thoughts are just thoughts, and may not be actionable. Every single comment should be taken with a grain of salt, and facts checked and corroborated prior to doing anything.

I've been thinking about the remaining NVCC non-compliant bank preferreds quite a lot lately. Most of these have been called (in advance of or at previous reset dates), and new NVCC compliant issues have been issued by the big banks in advance of Jan 1, 2022.

By my count, I think there are only a handful of these remaining, and most are trading at or near par. Two of the more interesting issues are BMO.PR.Q, and BNS.PR.Z (fixed resets), and their floating counterparts.

The specs on these two issues are as follows:

BMO.PR.Q, fixed reset, annual dividend of $.45, payable quarterly on each of Feb 25/May 25/Aug 25/Nov 25, spread is 5 YR Gov C Yld + 1.15%, next reset date is Aug 25, 2021. Current dividend yield of $.45 / $22.41 (at today's bid price) = 2%

YTM (assuming this issue gets called on Aug 25, 2021), using today's ask: approximately 5.9%

(see my rough calculations below)

BNS.PR.Z, fixed reset, annual dividend of $.52, payable quarterly on each of Jan 31/Apr 30/Jul 31/Oct 31, spread is 5 YR Gov C Yld + 1.34%, next reset date is Feb 2, 2021. Current dividend yield of $.52 / $23.38 (at today's bid price) = 2.2%

YTM (assuming this issue gets called on Feb 2, 2021), using today's ask: approximately 5.12%

(see my rough calculations below)

Some further thoughts on these issues, according to my understanding:

A number of years ago (back in 2013), the OSFI changed the rules regarding what type of securities could be included and counted toward Canadian bank Tier 1 capital (after the 08 crisis). The OSFI specifically excluded certain types of Canadian bank preferred shares, so since 2013, Canadian banks have been redeeming the old non-compliant preferreds and they have been issuing new compliant preferreds.

Case in point:

Bank of Montreal had many series of non compliant preferreds and they have been redeeming them at par ($25), and issuing new NVCC compliant preferreds instead.

Back in March 2018

See below, BMO series 16, 3.39%, BMO.PR.M, preferreds were non compliant, and they paid a quarterly dividend of $.2125 cents per share (source CIBC WG preferred share report, March 2018, link here)

The dividends are taxed preferentially and are eligible for the enhanced DTC

The key to understanding these preferreds is that the dividend is reset every five years at the then government of Canada 5 year bond yield, plus a spread. In this case, BMO.PR.M was to reset on August 25, 2018, and would have been extended if it was NVCC capital compliant.

BUT, that did not happen this year, what ended up happening is that BMO redeemed these preferreds at par ($25) on August 22, 2018.  See below, they are now defunct, because they were called by BMO.

So the yield to maturity assuming you would have bought the BMO.PR.M preferreds back in March 2018 at $24.81 was around 2.46%. Not great. Why bother right?

Well, look at what’s been happening to rate reset preferreds lately (as in over the last two months):

It’s been a bloodbath:

There’s a reason why I think this is happening: I think it’s because the index consists mostly of fixed reset preferreds that have little chance of being redeemed, and expectations for future increases in the Canada 5 year bond yield have been falling. And the expectation of a lower Canada 5 year bond yield plays havoc on the to be determined future dividends, right?

If a preferred share with no maturity resets in December 2020 at the Canada 5 year bond yield in December 2020 plus a spread of 2%, and the expectation for yields starts dropping now, the market starts discounting in lower dividends, which causes preferreds to implode, and selling begets more selling because I think that the people who buy preferreds are mostly retail investors who may not understand what they are buying. 

This then becomes technical in nature due to the overall illiquidity of the preferred market, and the ETF’s themselves have to sell to rebalance once everyone else starts selling, which causes more selling. The brokers and the market makers must make a killing. And the retail investor suffers because they watch the market tank and don’t understand why it’s tanking.

Now look comparably at what's happened to BMO.PR.Q (and to a lesser extent, BNS.PR.Z):

I believe this represents a nice opportunity to lock in a tax efficient YTM of between 5% and 6% if these issues get called in advance of Jan 1, 2022. The main risk here is that these issues do not get called and you end up stuck with a very low reset perpetual issue and are subject to the vagaries of preferred share implosion land if the GOC 5YR resets at near zero again in 2021 (anything is possible).

Full disclosure, I own BMO.PR.Q at $22.07.