Tuesday, April 07, 2009

Capital Trust Securities Q & A

  
CIBC Wood Gundy, Kory Brewster - Director, Fixed Income & Currencies, April 2009

Financial institutions have been issuing Capital Trust Securities (CTS) recently, prompting some questions by investors. CTS are investment grade debt instruments that currently offer attractive returns while still providing the stability common to bonds.

How Are They Structured – Why 99 Years?

Capital Trusts are structured as wholly owned trusts of the issuing financial institution. The trust holds an income-generating asset, such as a bank deposit note, which provides the funds to make coupon and principal payments to CTS holders.

Regulators require financial institutions to maintain specific levels of capital to provide depositors with protection against unexpected losses. The recent credit crunch has motivated many financial institutions to raise their capital ratios to satisfy regulators and investors alike, resulting in the issuance of new preferred and common shares, and CTS. To qualify as Tier 1 Capital, CTS must have 99 years to maturity, although their structure makes early redemption likely (more on that later).

CaTS, BaTS, BOaTS, CoaTS, TruCS, MaCS, SLEECS

The CTS available in Canada are named TD CaTS, BNS BaTS, BMO BOaTS, CIBC CoaTS, RBC TruCS, Manulife MaCS, Sun Life SLEECS, Great West GreaTS and Canada Life CliCS. While somewhat fun just to rhyme off, the significance of the names is that they all contain the letters “TS,” which stands for Trust Securities, or ”CS,” which stands for Capital Securities.

Why Are CTS Yields So High?

When investors see investment grade debt that yields 8% and higher, it gets their attention. Some may wonder why securities issued by high-quality financial institutions would have such high yields. There are five primary reasons.

Firstly, credit risk is a concern when holding these products since senior bonds have priority in the case of liquidation or asset distribution. For this reason, the credit rating for these products is lower than that for similar deposit notes.

Secondly, extension risk is the risk that the CTS will remain outstanding longer than the anticipated redemption date. Moreover, in cases where the regulator deems the issuer to be financially distressed, CTS could be converted into perpetual preferred shares.

Thirdly, interest is a pre-tax expense, making it more tax-efficient than dividends for the issuer. Yet for the investor, interest is taxed at a higher rate than are dividends; hence, the higher CTS yields help make their yields similar to those on preferred shares on an after-tax basis.

Fourthly, when trying to raise capital, issuers want to be sure that the deal is well received by the marketplace and that they are able to raise all the capital they require. The coupon rates on the last three CTS issues were all over 9.5% and all three issues were highly demanded.

Finally, the high yields are also a result of the ongoing credit crunch that has lifted the cost of borrowing. Some of the first CTS, which were issued back in 2000, offered yields that were about 150 basis points (bps) higher than that of a comparable Government of Canada (GoC) bond. The three most recent issues provide yield spreads of more than 650 bps.

What If Interest Rates Rise?

Interest rate risk is the risk that rising interest rates cause bond prices to fall. However, bond market yields would be expected to rise only as the economy recovers and inflation starts to creep higher. With the economy improving, it would be expected that yield spreads would start to narrow as the risk of default declines. Thus, there would then be two competing forces: rising government bond yields and tightening yield spreads. Yield spreads have increased much more than government bond yields have decreased during the crisis so if conditions revert to ”normal,” CTS prices could remain stable or even increase.

Where Do They Rank?

CTS are junior subordinated debt instruments which rank lower than senior debt. In situations of financial distress, all CTS are exchangeable into non-cumulative preferred shares at the issuer’s option. Therefore, they rank pari passu (equal) with preferred shares from a financial weakness/bankruptcy perspective. However, in terms of distributions, CTS have a “Dividend Stopper Undertaking” feature that prohibits the payment of any preferred or common share dividends if an interest payment owed to CTS holders is missed. Thus, from a distribution perspective, they rank ahead of preferred and common shares.

Will They Be Redeemed Early?

There are two compelling reasons why CTS are likely to be redeemed at their initial redemption dates, which are usually 10 to 30 years after their issuance dates. First, some of the older CTS give investors the right to exchange their holdings into preferred shares that in turn can be exchanged at principal value for common shares at a discount, which most issuers would prefer to avoid. As for the more recently issued CTS, if not redeemed, their coupon rates will reset to a specified Bankers Acceptance rate or GoC bond yield plus a very large spread. Second, issuers may face reputational risk, as investors purchased these products under the assumption that they would be redeemed early and that the 99 year final maturities were only there to satisfy regulatory requirements. If the issuer fails to redeem them early, they may have a difficult time raising capital using similar instruments in the future.

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