Extendible Note issuances have become increasingly popular in the last few years as a way for Canadian banks to raise capital. While Extendible Notes may seem attractive on the surface, investors should be cautious about adding them to their portfolios.
Extendible Notes are similar to multi-year Guaranteed Investment Certificates (GICs) with some very important differences. A typical Extendible Note might have a five year term with a different pre-determined fixed rate of interest in each year. For example, an interest rate of 2% might be offered for years one and two, 3% for year three, 4% for year four and perhaps 4.5% for year five. After year five, the holder of the Extendible Notes is entitled to cash in their investment.
At first look, these notes seem appealing because the interest rates offered may be significantly higher than those available from regular GICs or investment grade fixed income securities. The problem, however, is that the issuer of the Extendible Notes (i.e. the bank) has the option to redeem them at the end of each year, paying only the principal and interest owed up to the redemption date.
Regardless of one’s view of the direction of interest rates over the next several years, it is difficult to see how Extendible Notes are a good choice for investors when the issuing bank has this annual redemption right.
Our view at Bridgeport Asset Management is that Extendible Notes mainly benefit the issuing bank and are generally a losing proposition for the investor. For example, if interest rates rise significantly in the future, the notes will turn out to be of greater benefit to the issuing bank. The bank will not redeem them as the rate to raise new capital would be higher than the rates on the Extendible Note. The investor, on the other hand, will be upset about being locked into a note that is paying a rate of interest less than what is available in the market on similar investments.
Alternatively, if interest rate levels remain unchanged or decline in the future, the issuing bank will likely choose to redeem the notes and raise capital at a lower interest rate than it would have otherwise paid on the Extendible Note. In this scenario, the Extendible Note investors might rightfully complain that the high future rates of interest originally offered to them were used as a “teaser” to get them to invest. The only way the investor would ever earn the higher rates of return on the Extendible Note would be if interest rate levels rose so quickly that the Extendible Note rate of return turned out to be lower than the market rate of interest.
So as you can see, we are not in favour of investing in Extendible Notes. Investors seeking safety and income would be better off investing in plain vanilla GICs or investment grade bonds. Feel free to let us know what you think.