A new Additional Tier 1 (AT1) bond, known as a Limited Recourse Capital Note (LRCN), has been introduced to the Canadian market. It’s a type of unsecured, long-dated bond banks can use to enhance their core capital base to satisfy Basel-III criteria. LRCN AT1 bonds have several unique features in the fine print, which make them very different from regular bonds.
These bonds sit below a bank’s subordinated debt and alongside preferred shares in the capital stack. The capital stack sets out how the various categories of equity and debt rank and where investors sit when it comes to taking losses. LRCN AT1 bonds offer higher yields than higher-quality bank senior and sub-debt, but also present some rather unique risks.
AT1 issues are hybrid offerings of subordinated debt or preferred shares that can be converted into common stock if a trigger event occurs. Investors could also receive preferred shares.
These bonds are tradable and expected (but not always required) to make regular coupon payments. They rank one rung above common equity in the capital stack. LRCN AT1 bonds constitute the riskiest type of bank debt and are the first to take losses in any sort of crisis.
How do they work?
LRCN AT1 bonds issued by Canadian banks are all expected to have at least 60-year maturities. Many will carry call options that allow the issuing bank to redeem them after a prescribed period of time and/or under certain conditions.
The call options on these bonds allow issuing banks to redeem them at certain pre-specified intervals – usually 5 years. But the banks are not obliged to exercise this call option and can opt to continue paying interest on these bonds.
The Office of the Superintendent of Financial Institutions (OSFI) decided that issuing banks have full discretion to trigger the delivery of preferred shares to the LRCN holders in lieu of making interest payments. In that case, the LRCNs would be cancelled. Foregone interest payments would be cancelled too as they are non-cumulative and do not result in events of default or any other restrictions.
Issuing banks can only skip interest payments or reduce the bonds’ face value if their capital ratios fall below certain threshold levels. These thresholds are specified in the offer terms.
What is the origin of LRCN AT1 bonds?
The LRCN AT1 bond structure in Canada was authorized by OSFI in July 2020, when the regulator announced that the newly-proposed LRCNs issued by federally-regulated financial institutions would meet all of the criteria for the instrument to be recognized as AT1 regulatory capital.
Royal Bank of Canada (RBC) successfully completed the first issuance of AT1 bonds in Canada in July 2020, with an offering that was oversubscribed. The offering was structured to include lower-ranking LRCNs with a 60-year maturity and non-cumulative preferred shares that would be issued to investors if the bank needed to act to maintain certain capital requirements.
Other banks quickly followed suit as there appeared to be plenty of appetite in the market.
Who’s investing in these LRCN AT1 bonds and why?
Institutional investors – think pension funds, ETFs and mutual funds – are the target market for this type of bond. In fact, they can only be sold to institutional investors. And while there is definitely additional risk versus traditional bond issues, investors receive a yield premium to compensate for at least some portion of this incremental risk.
Professional managers must evaluate the merits of moving further out on the risk spectrum for incremental yield — something they should only do if they are being compensated for taking on that additional risk.
Whenever a bond offers extra yield, you need to look out for the wolf in sheep’s clothing. But, the incremental spreads of the first LRCN AT1 issues have clearly caught the interest of Canadian investors.