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Scotiabank’s AT1 security a hit; other banks expected to follow suit

The Bank of Nova Scotia stands in Toronto, Ontario, Canada, on Tuesday, Feb. 5, 2013.

Reynard Li/Bloomberg

More Canadian banks and possibly life insurers are expected to follow Bank of Nova Scotia's lead and take advantage of a novel source of funding that has proven to be a hit with investors, bankers and analysts say.

Last week, Scotiabank raised $1.25-billion (U.S.) from institutional investors mostly in the United States, Europe and Asia through the sale of a new hybrid security that has many attributes of preferred shares, but is legally debt. The notes were crafted in such a way that the money raised qualifies as additional tier 1 (AT1) capital, which is part of a cash reserve that Canada's top banking regulator expects banks to hold to maintain a minimum level of financial stability.

The Canadian banks have primarily raised this type of capital by issuing preferred shares into the domestic market, which is heavily dependent on retail demand. But preferred shares have been a tough sell for banks to export beyond Canada because Canada Revenue Agency puts a tax of 25 per cent on any passive income generated by investors who are not residents of Canada.

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Scotiabank's hybrid note was well-received partly because it was structured in such a way that avoids this tax on foreigners. It also offers investors a yearly interest rate of 4.65 per cent in the first five years and a floating rate after that. It has no scheduled maturity, and converts into equity during times of distress, satisfying the banking regulator's requirements.

Scotiabank lined up 330 interested institutional buyers and amassed an order book that was about seven times oversubscribed, Vivek Selot, an analyst at RBC Dominion Securities Inc., said this week in a research note. The deal was led by UBS AG and featured Scotia Capital Inc., Merrill Lynch, and Citigroup Global Markets Inc. as joint bookrunners.

Scotiabank declined comment on the offering.

Greg McDonald, the director of debt capital markets at TD Securities Inc., called the AT1 issuance "an important step" in Canadian banks' bid to gain access to additional U.S. dollar funding avenues. "Any time you can open up a new market for either funding or capital … it's definitely a plus," he said.

He expects many of the Canadian banks to consider it as a new potential future source of funding, and weigh it against existing options such as preferred shares.

BMO Nesbitt Burns Inc. analyst Kris Somers called Scotiabank's note a "gamechanger," adding in a report that the new structure has the potential to result in reduced supply of preferred shares sold by financials.

This type of offering is being billed as a solution to a problem that Canada's largest financial institutions have been wrestling with for years: The country's market for preferred shares has become a less reliable and more costly way of sourcing AT1 capital.

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In 2015, it became clear that the preferred-share market in Canada was encountering stumbling blocks.

After the financial crisis, banks sold preferred shares with a built-in feature that would see the dividend rates reset after a certain period of time. This was done so that when interest rates eventually rose as the economy recovered, so, too, would the income generated by the shares. Except, by 2015, interest rates were not rising – they were still falling. The dividends were resetting lower and investors were earning a lot less, spurring mass selling and pushing preferred-share prices lower.

Opportunistic institutional investors stepped up to fill the void, demanding hefty dividend yields. Banks had little choice but to pony up and swallow the costs. The episode spurred banks and their lawyers to look for another way of sourcing these funds. Two years later, Scotiabank has done just that.

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About the Authors
Capital Markets Reporter

Christina Pellegrini is a reporter at The Globe and Mail and a regular contributor to Streetwise, covering capital markets, the exchange business and market structure.She writes about the capital markets divisions of BMO, CIBC and National Bank; independent brokerages such as Canaccord Genuity; and the Canadian operations of foreign dealers including JP Morgan, Goldman Sachs, Credit Suisse and Citigroup. More

Capital Markets Reporter

Niall McGee joined the Globe and Mail in 2014 as a capital markets reporter. Previously, he spent a decade at Business News Network (BNN) as a reporter and segment producer. In 2016, he won a National Newspaper Award (NNA) in business alongside veteran reporter Jacquie McNish for an investigative series into alleged insider trading at online gambling company Amaya Inc. More

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