Skip to main content

Some advice for Canadians searching for yield: Before buying another bank-issued preferred share, study the drama unfolding at some of Europe's biggest financial institutions.

For the past few years, Canadians have been eager to gobble up new preferred-share issues sold by the country's largest lenders. These offerings often promise annual yields between 4 per cent and 5 per cent – juicy returns in an era of rock-bottom interest rates.

Lately, investor appetite for them has been almost insatiable. Earlier this month, Bank of Montreal hoped to sell $350-million worth of preferred shares, but saw so much demand it raised the issue size to $600-million. In August, Toronto-Dominion Bank looked to raise $300-million worth of new shares, but ended up selling $1-billion.

Banks like selling these securities because they are structured in such a way to count as capital that can cushion against bad loans and losses. The shares carry a clause that states they can be converted to common equity in an emergency – earning them the label of non-viability contingent capital (NVCC).

Royal Bank of Canada was the first bank to test the NVCC preferred share market in January, 2014, and its $500-million offering sold out quickly.

Investors largely buy them for their fat, stable dividends and their ranking above common shares in the bank's capital structure, meaning their holders are better protected if a restructuring is ever needed. But the owners in fact shoulder some of the burden of recapitalizing the bank if necessary. Regulators like this because it puts shareholders on the hook, rather than taxpayers.

The recent fervour for these deals suggests investors may be too quick to overlook that. As it stands, investors have almost every reason to trust Canadian banks – they withstood the shocks of the Great Recession, and they post some of the best returns on equity in the world today. However, it is nearly impossible to predict the future. The current action in Europe shows how risks can emerge.

In Germany, Deutsche Bank, one of the world's largest financial institutions, is raising concerns amid worries about its profitability, and in Italy, a good swatch of the banking sector is reeling from bad loan portfolios. Both Deutsche Bank and UniCredit, one of Italy's largest lenders, have issued contingent convertible debt, so-called CoCo bonds, that act much like Canada's NVCC shares – they convert to common equity in a crisis. In 2016, a number of European CoCo bonds have taken it on the chin. UniCredit's €1-billion ($1.4-billion) issue fell to 72 cents on the euro, far from the original par value, and in September, Deutsche Bank's €1.75-billion issue dropped to 69.97 cents amid fears about regulatory fines and anaemic future profits.

For Deutsche Bank, fears of conversion subsided somewhat in October, and the CoCo bond now trades for roughly 80 cents, but this still proves these securities aren't always safe, steady invesments that pay a solid yield.

There are myriad differences between the Canadian banks and their troubled European peers. Still, not so long ago, the chance that investors in Deutsche Bank's senior-ranking securities, or those of Italian lenders, would be bruised by growing worries about a possible crisis seemed rather farfetched, too.

Follow related authors and topics

Authors and topics you follow will be added to your personal news feed in Following.

Interact with The Globe