Canadian banks have been busy raising capital. Like every other bank around the world, they are shoring up their balance sheets in response to increasing loan defaults and the write downs occurring on some of their asset base.

Investors, weary of declining markets and scary headlines, have been reluctant to pour more of their hard earned savings into assets that are not directly backed by the Canadian government. Corporate issuers must come up with very compelling offers to gain any interest from bruised investors.

To entice investor capital, banks have been issuing preferred shares – but with a twist. To highlight the difference between the reset preferred shares and the more typical preferred share, first take a look at the typical bank preferred share.

The most common type of preferred share is known as a “perpetual” preferred share. The “perpetual” refers to the fact that these shares are not redeemable (by the investor) at par on any set date. Once the yield is set at issue, this yield stays fixed, meaning that the capital value of the share will move up and down depending on what current rates are doing. If you bought at perpetual preferred share with a 4% yield and current yields go to 6% – to sell this 4% share, you are going to have to take a big haircut on share price to make the yield attractive.

Banks know that the perpetual preferred share will likely get a lukewarm response in these tough economic times. Investors are too concerned with the threat of inflation or deteriorating credit conditions to enter into “perpetual” maturities.

Enter the “reset” preferred share. These shares are called reset preferred shares because every five years the dividends get reset to a new rate. While the terms differ depending on the issuer, the last few issues have had their initial yield set at *6.25% – 6.65%. The “reset” basis in five years is the 5-year Government of Canada bond rate plus some spread. The spreads have been between 4.15% and 4.6%. To give an example, if the

5-year Canada bond is paying 2% in 2014, and the shares offer a spread of 4.15% over the 5-year Canada bonds, then the investor has their dividend “reset” to 6.15% for the next five years.

These 6% plus yields, combined with the reset feature, have investors lining up to buy these issues. The yield is not only very attractive, it also gets taxed as a Canadian dividend, making it worth much more after tax than taxable interest income.

Reset preferred shares are attractive, but they are not guaranteed. If a bank goes out of business, the preferred shares go out with the institution. The dividends are also “non cumulative” which means if the bank skips a dividend payment, they do not have to catch up in the future. It is worth noting that there is a big hurdle to cross before the bank can skip a preferred share dividend. A preferred share dividend takes precedence over a common share dividend. To skip a preferred share dividend, they first have to cut the common share dividend to zero.

Investors with cash set aside are not earning much these days. Rates are nearing historic lows with the Canadian government 5 year bond yield under 2%. Against this backdrop, reset preferred shares are looking pretty good.

* Yields on Five-Year Reset Preferred shares are available at: www.sedar.com

Alan MacDonald is an Investment Advisor with Richardson Partners Financial Ltd. Alan helps investors with over $500,000 of assets make smart decisions about money. For more information please visit www.alanmacdonald.ca or e-mail Alan at Alan.Macdonald@RichardsonGMP.com

Richardson Partners Financial Limited is a member of CIPF