DBRS Morningstar Upgrades Financial 15 Split Corp. Preferred Shares

DBRS Limited (DBRS Morningstar) upgraded the rating of the Preferred Shares issued by Financial 15 Split Corp. (the Company) to Pfd-3 from Pfd-3 (low). The Company invests in a portfolio (the Portfolio) consisting primarily of common shares of 15 high-quality North American financial services companies: Bank of America Corporation; Bank of Montreal; The Bank of Nova Scotia; Canadian Imperial Bank of Commerce; CI Financial Corp.; Citigroup Inc.; The Goldman Sachs Group, Inc.; Great-West Lifeco Inc.; JPMorgan Chase & Co.; Manulife Financial Corporation; National Bank of Canada; Royal Bank of Canada; Sun Life Financial Inc.; The Toronto-Dominion Bank; and Wells Fargo & Company. In addition, up to 15% of the net asset value (NAV) of the Company may be invested in securities of issuers other than those mentioned above. These issuers include Fifth Third Bancorp and AGF Management as of November 30, 2021. No more than 10% of the NAV of the Company may be invested in any single issuer. The Portfolio is actively managed by Quadravest Capital Management Inc.

A portion of the Company’s Portfolio is exposed to currency risk as it includes securities denominated in U.S. dollars (USD), while the NAV of the Company is expressed in Canadian dollars. The Company has not entered into currency hedging contracts for the USD portion of the Portfolio, although the Company may use derivatives for hedging purposes. As of November 30, 2021, approximately 41.5% of the Portfolio was invested in USD-denominated assets.

The Company established an at-the-market (ATM) equity program in October 2019, which was renewed and is currently effective until December 22, 2023. The ATM equity program allows the Company to issue Preferred Shares and Class A Shares to the public from time to time at the Company’s discretion, through the Toronto Stock Exchange or any other marketplace in Canada where the shares are listed. The Company also issues Preferred Shares and Class A Shares from time to time through overnight offerings. Preferred Shares and Class A Shares are issued only on a basis that an equal number of Preferred Shares and Class A shares will be outstanding at all material times.

The Company’s termination date is December 1, 2025. At maturity, the holders of the Preferred Shares will be entitled to the value of the Company, up to the face amount of the Preferred Shares, in priority to the holders of the Class A Shares. Holders of the Class A Shares will receive the remaining value of the Company. The termination date can be extended for additional terms of five years at the Company’s discretion, but shareholders are provided with a special retraction right in connection with such extension.

Pursuant to the special retraction right in connection with the extension of the Company’s termination date from December 1, 2020, to December 1, 2025, the Company redeemed more Preferred Shares than Class A Shares in December 2020. As more Preferred Shares were tendered for retraction, the Class A Shares were consolidated on the basis of 0.4 of a post-consolidation Class A Share for every one pre-consolidation Class A Share outstanding. The organization resulted in an increase in NAV per unit and the subsequent reinstatement of monthly dividends paid to Class A shareholders.

Holders of the Preferred Shares are currently entitled to a fixed cumulative monthly dividend of $0.05625 per share, yielding 6.75% annually on their issue price of $10 per share. Holders of the Class A Shares currently receive regular monthly cash distributions in the amount of $0.1257 for each share. No regular monthly distributions will be paid to the Class A Shares if the NAV per unit is below the $15 threshold or if any dividends on the Preferred Shares are in arrears.

Following the reorganization, the downside protection has continued to increase as a result of higher share prices of the underlying common shares of the Portfolio. Downside protection increased to 55.9% as of February 15, 2022, from 49.9% in February 2021. Downside protection available to the Preferred Shares consists of the NAV of the Class A Shares. The dividend coverage was 0.6 times. The average grind on the Portfolio is expected to be 9.3% annually for the remaining term to maturity. To supplement dividend income received on the Portfolio, the Company may engage in option writing.

Based on the increased amount of downside protection and time remaining until maturity, DBRS Morningstar upgraded the rating on the Preferred Shares to Pfd-3 from Pfd-3 (low).

The main challenges are

(1) The downside protection available to holders of the Preferred Shares depends on the value of the common shares held in the Portfolio.
(2) The reliance on the Portfolio manager to generate additional income through methods such as option writing.
(3) The monthly cash distributions to holders of the Class A Shares, which create grind on the Portfolio.
(4) The unhedged portion of the USD-denominated Portfolio that exposes the Portfolio to foreign currency risk.

A description of how DBRS Morningstar considers ESG factors within the DBRS Morningstar analytical framework can be found in the DBRS Morningstar Criteria: Approach to Environmental, Social, and Governance Risk Factors in Credit Ratings at https://www.dbrsmorningstar.com/research/373262.

Notes:
All figures are in Canadian dollars unless otherwise noted.

The principal methodology is Rating Canadian Split Share Companies and Trusts (June 28, 2021), which can be found on dbrsmorningstar.com under Methodologies & Criteria.

The DBRS Morningstar Sovereign group releases baseline macroeconomic scenarios for rated sovereigns. DBRS Morningstar analysis considered impacts consistent with the baseline scenarios as set forth in the following report: https://www.dbrsmorningstar.com/research/384482.

The related regulatory disclosures pursuant to the National Instrument 25-101 Designated Rating Organizations are hereby incorporated by reference and can be found by clicking on the link under Related Documents or by contacting us at info@dbrsmorningstar.com.

The rated entity or its related entities did participate in the rating process for this rating action. DBRS Morningstar had access to the accounts and other relevant internal documents of the rated entity or its related entities in connection with this rating action.

For more information on this credit or on this industry, visit www.dbrsmorningstar.com or contact us at info@dbrsmorningstar.com.

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