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(Bloomberg) — Investors searching for an edge in frothy credit markets are snatching up an obscure type of Canadian debt that’s already delivered some of the best returns among bonds. 

The securities — a type of Additional Tier 1 capital called Limited Recourse Capital Notes — have been issued by Canadian banks in recent years as a backstop to absorb capital losses if the bank runs into trouble, at which point they convert to equity. Known as LRCNS, the notes are mostly rated in the lower tier of investment grade, they have ultra-long maturities and are callable in as soon as five years after issuance.

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Traditional credit investors have long expected banks to buy back the LRCNs at the earliest opportunity through calling them, to refinance the securities. But central bank rate hikes have made banks less interested in refinancing the debt, as calling certain LRCNs would often amount to replacing cheaper debt with more expensive obligations.

Investors realized that securities they thought they would be holding for five years, then selling back to the bank that issued them, could end up remaining outstanding for much longer, weighing on their returns. That, in turn, prompted selling that sent the debt into a tailspin, driving prices to as low as 70 cents on the dollar in some cases.

Even as typical buyers retreated, new ones have appeared. These investors are looking past the increase in so-called extension risk to capture the higher yields LRCNs offer compared to same-rated debt. Their entry helped notes rebound to their highest levels since 2022, gaining around 14% in some cases after hitting bottom last fall to become some of the best-performing bonds in credit this year, according to data compiled by Bloomberg. 

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“Relative to other BBB paper in the Canadian corporate universe, it looks like pretty good value to me,” said Adrienne Young, senior vice president and director of credit research at Franklin Templeton Canada. 

The average low-investment-grade Canadian corporate bond currently yields around 1.42% over the Canadian benchmark, or about 5.2%, data compiled by Bloomberg show. By comparison, the average yield-to-perpetuity for LRCNs stands at 7.9%.

The AT1 market was thrown into turmoil last year, after Credit Suisse collapsed, and AT1s absorbed losses, while common shares didn’t, raising investor fears that the bonds were generally riskier than previously understood. In Canada soon after that, the nation’s financial regulator assured investors that common shareholders would sustain losses first, before AT1 investors were hit.

Adding to their appeal as a relatively safe investment, Canadian banks are highly profitable and very well-capitalized with a long dividend-paying history, said Himanshu Bakshi, credit analyst at Bloomberg Intelligence. 

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The interest in LRCNs by a new crop of buyers matches a surge in demand for similar types of AT1-related debt, such as Restricted Tier 1 notes sold by European insurers. LRCNs have drawn international buyers too, with banks issuing in US dollars at competitive rates. US dollar-denominated LRCNs have an average yield-to-perpetuity of 8.1%, compared with the global high-yield average at 7.7%, according to data compiled by Bloomberg.

Read more: Bond Investors Are Clamoring for Niche Type of AT1-Like Debt

A decline in borrowing costs may increase the chance that the LRCNs are redeemed. But investors need to “consider the reality that these are going to be perpetual instruments,” said Andrew Labbad, senior portfolio manager at Wealhouse Capital Management, a Toronto-based money manager.

Take Royal Bank of Canada’s C$825 million ($611 million) note due in 2081. The bank could choose not to redeem the bond when it becomes callable in 2026 and instead reset the coupon at 266.5 basis points over the five-year Canadian government curve. That relatively narrow spread means these LRCNs are very cheap tier-one funding for the banks, Labbad said in an interview with Bloomberg. 

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Still, the higher yields appear cushion enough for many investors, for now. 

For borrowers, there is incentive to take advantage of demand. Canadian online bank and mortgage ender EQB Inc. is looking to potentially tap the market with its first issuance of LRCNs later this year, Chief Executive Officer Andrew Moor and Chief Financial Officer Chadwick Westlake said in an interview with Bloomberg last week.

The risky debt became a “bit of a debate” in global markets last year, but investors are growing comfortable with them again, said Moor. 

—With assistance from Tasos Vossos, Esteban Duarte and Christopher DeReza.

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