DBRS Limited (DBRS Morningstar) downgraded its credit rating on the Preferred Shares issued by Canadian Banc Corp. (the Company) to Pfd-3 (low) from Pfd-3. The Preferred Shares have experienced a reduction in downside protection. Macroeconomic factors, including central banks’ responses to inflation levels and geopolitical tensions like the Russia-Ukraine war, have led to increased volatility in equity markets for most of 2023. In addition, the closures of certain U.S. regional banks because of liquidity and solvency concerns led to widespread and significant declines in the equity market prices of financial services companies in the United States and Canada. Consequently, this affected both the Company’s net asset value (NAV) and downside protection, especially in 2023.
As of August 31, 2023, the Company invested in a portfolio of common shares of the six largest Canadian banks representing approximately 57.7% of the portfolio: Royal Bank of Canada (16.5%), The Toronto-Dominion Bank (13.3%), National Bank of Canada (9.2%), Bank of Montreal (8.8%), Canadian Imperial Bank of Commerce (5.0%), and Bank of Nova Scotia (4.9%). The Company may invest up to 20% of the NAV in equity securities of Canadian or foreign financial services corporations other than the core holdings mentioned above. As of August 31, 2023, 16.1% of the portfolio was invested in five well-known U.S. financial services companies (Morgan Stanley, JP Morgan Chase, Bank of America, Goldman Sachs, and Citigroup Inc.) and 26.0% was held in cash and cash equivalents. As mentioned above, 16.1% of the portfolio was invested in U.S. financial services entities and denominated in U.S dollar (USD). The Company has not hedged its USD exposure to currency fluctuations; however, it closely monitors USD/Canadian dollar currency movements.
Holders of the Preferred Shares receive monthly distributions at a rate of Prime + 1.5% per annum (minimum 5.0%, maximum 8.0%), currently 8.0%. Holders of the Class A Shares are entitled to receive monthly cash distributions targeted to be at a rate of 15% annually based on the volume weighted-average market price of the Class A Shares for the last three trading days of the preceding month. The Company announced the extension of the termination date for a further five-year period to December 1, 2028, from December 1, 2023. In connection with the term extension, the Company decided to maintain the distribution rate for the Preferred Shares at the existing rates. No monthly distributions to the Class A Shares will be made if the dividends of the Preferred Shares are in arrears or the NAV of the portfolio falls below $15 per unit.
Over the past 12 months, downside protection has been volatile. As of October 31, 2023, downside protection stood at 44.8%, down from 51.7% as of October 31, 2022. The Preferred Shares’ dividend coverage based on the current dividend yield on the portfolio was 0.6 times (x). Without giving consideration to the capital appreciation potential or any source of income other than the dividends earned by the portfolio, the targeted monthly distributions to the Class A Shares along with the Preferred Shares’ dividend coverage shortfall are likely to create an average annual grind on the portfolio’s NAV equivalent to 5.4% over the remaining term to maturity. To supplement portfolio income, the Manager may engage in covered call option writing on all, or a portion of, the securities held in the portfolio or rely on realized capital gains.
DBRS Morningstar notes the following announcements from the Company during the past 12 months:
(1) On January 31, 2023
Completed an overnight treasury offering of Class A and Preferred Shares, raising approximately $45.1 million in gross proceeds. The Class A Shares were offered at a price of $13.75 per share for a yield to maturity of 14.47%, and the Preferred Shares were offered at a price of $10.00 per share for a yield to maturity of 7.95%.
(2) On March 2, 2023
Extended the termination date of the Company for a further five-year period to December 1, 2028, from December 1, 2023.
(3) On May 19, 2023
Renewed its at-the-market (ATM) Program effective until June 18, 2025, which allows maximum gross proceeds of $140 million. The ATM Program allows the Company to issue Class A Shares and Preferred Shares from time to time at the Company’s discretion.
(4) On May 25, 2023
Announced that the Toronto Stock Exchange (the TSX) has accepted its notice of intention to make a Normal Course Issuer Bid (the NCIB) to purchase its Preferred Shares and Class A Shares through the facilities of the TSX and/or alternative Canadian trading systems. The NCIB commenced on May 29, 2023, and will terminate on May 28, 2024.
(5) On September 21, 2023
Announced that it will maintain the distribution rates for both the Class A Shares and Preferred Shares at existing levels.
Giving consideration to the decline in downside protection, the extension of the Company’s termination date for a further five-year term, the projected grind in the portfolio from expected distributions on the Class A Shares and the Preferred Shares’ dividend coverage shortfall, concentration of the portfolio in one industry and the unhedged foreign exchange exposure, DBRS Morningstar downgraded the credit rating on the Preferred Shares to Pfd-3 (low) from Pfd-3.
The main constraints to the credit rating are the following:
(1) Market fluctuations resulting from high inflation and interest rate hikes could affect the Company’s NAV. Resulting volatility in prices along with changes in the dividend policies of the underlying issuers may result in significant reductions in the Preferred Shares’ dividend coverage or downside protection from time to time.
(2) Reliance on the Portfolio Manager to generate additional income, through option writing, to meet distributions and other trust expenses without having to liquidate the portfolio’s securities.
(3) The high concentration of the portfolio in one industry (banking).
(4) Potential foreign exchange risk because the income received on the portfolio is not hedged all the time.
(5) Stated monthly distributions on the Class A Shares may create a grind on the portfolio. This risk is mitigated by an asset coverage test of 1.5x that ensures sufficient levels of downside protection to the holders of the Preferred Shares.
ENVIRONMENTAL, SOCIAL, AND GOVERNANCE CONSIDERATIONS
There were no Environmental/Social/Governance factors that had a significant or relevant effect on the credit analysis.
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/416784 (July 4, 2023).
All figures are in Canadian dollars unless otherwise noted.
The principal methodology applicable to the credit rating is Rating Canadian Split Share Companies and Trusts (June 16, 2023; https://www.dbrsmorningstar.com/research/415986).
Other methodologies referenced in this transaction are listed at the end of this press release.
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 firstname.lastname@example.org.
The credit rating was initiated at the request of the rated entity.
The rated entity or its related entities did participate in the credit rating process for this credit rating action.
DBRS Morningstar had access to the accounts, management, and other relevant internal documents of the rated entity or its related entities in connection with this credit rating action.
This is a solicited credit rating.
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The credit rating methodologies used in the analysis of this transaction can be found at: https://www.dbrsmorningstar.com/about/methodologies.
A description of how DBRS Morningstar analyzes structured finance transactions and how the methodologies are collectively applied can be found at: https://www.dbrsmorningstar.com/research/410863.
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