It may be junk but it’s cheap junk

May 14, 2009

REUTERS– Neil Collins is a Reuters columnist. The views expressed are his own –

Tuesday, May 12 was just another day in the twilight zone that is the market for bank debt and preference shares. As usual, that day’s dividends were paid on time, including the one due on Lloyds Banking Group 6.0884 percent preference shares.

The price hardly twitched; on Collins Stewart’s Thursday daily list, it was offered at 337.50 pounds per 1,000 pounds of stock, to produce a net yield of 18.0 percent.

That hefty return assumes the dividend will go on being paid. It may not be, and missed payments do not accumulate against that distant day when Lloyds returns to prosperity.

As last week’s trading update showed, that is still a long way away. Uncertainty looms over payments on prefs and on billions of pounds-worth of the banks’ junior debt, driving down the prices, and many who paid par value for them have sold because they can’t bear the sight of such a massive capital loss in their portfolios.

Anyone can see that bank prefs and subordinated debt issues are risky; the more interesting question is: are the risks correctly priced, or do they owe too much to the panic that followed the collapse of Lehman Brothers?

Oliver Butt, who specialises in distressed debt for institutional brokers City & Commercial, points out that only one UK bank has failed to pay its preference dividends since Barings collapsed in 1995.
The UK government confiscated the Northern Rock preference shares along with the ordinaries because it needed to obtain 100 percent of the voting rights.

Even Bradford & Bingley, the bank which was taken over and dismembered by the government last year, has paid up. Its lowest class of capital (above ordinary shares) is the former Permanent Interest-Bearing Shares (PIBS). Created when B&B turned into a bank, the 6 percent perpetual subordinated bonds stand at just 15 pence in the pound, to yield 40 percent.

In other words, if B&B keeps paying the interest for the next 2-1/2 years, a buyer would get his money back.

B&B’s legal status is far from clear, and UK Financial Investments, the state-owned holding company for its bank shares, may decide that the lower tiers of debt-holders should bear some of the pain of the banking crisis, which is currently shared between shareholders and taxpayers.

So far, though, its charges have made all the pref and bond payments as they became due.
If prefs and B&B bonds seem too risky to contemplate, here are Northern Rock’s former PIBS, now 12.625 percent perpetual subordinated notes. At 78, they yield 16.19 percent until hell freezes or the Rock hits the rocks, whichever comes sooner.

After a couple of U-turns by the government, Northern Rock is being run up rather than run down, and is in the middle of a capital reconstruction.

There is clearly risk here; it’s not entirely clear whether the dividend is cumulative, and missing a payment probably doesn’t count as an event of default.

The Banking Act 2009 seemed to rule that no coupon payments could be made until any loan from the state had been repaid, an interpretation that caused a further slump in the bond market, until the Treasury rushed out a “clarification” to say it that dividends were the bank board’s decision.

So perhaps 16.19 percent is too low a return compared to the risk. However, this market is nothing if not inconsistent, and there are hundreds of bonds — there are dozens from Northern Rock alone — many of which yield far more.

Take, for example, the 5.625 percent eurobond 2015. Price discovery is often tricky in these obscure, unlisted issues, but this seems to be offered at 42.5, for a gross yield to maturity of 31.54 percent — always assuming, of course, that the bank is still around in six years’ time.

This bond ranks above the subordinated notes, so it ought to yield less. The anomaly is a combination of ignorance and illiquidity, and any brave buyer should be prepared to lock it away until maturity in 2015.

For those who prefer to go further up the financial food chain, Britannia Building Society has just been taken over by the Co-Operative Group, and its PIBS have been turned into subordinated bonds. The security is much improved, and the dividend is cumulative. The 13 percent perpetual stock yields 9.85 percent at 132.

The “risk-free” equivalent to these perpetual stocks is War Loan, which yields 4.5 percent at 77.75. It’s easy to buy and sell, at a miniscule spread, but is it really worth giving up over 500 basis points of yield over the Britannia, or 1100 points for the Northern Rock perpetuals? I don’t think so, which is why I hold both of them in a tax-free Individual Savings Account.
(Neil Collins has an interest in Britannia and Northern Rock perpetutual stocks)
(Edited by David Evans)

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