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Are these bombed-out bonds worth buying?

April 24, 2009

Tier 1 bonds sound like better quality assets than Tier 2 bonds, but don’t be fooled. It’s the other way around, and T1 bonds rank only just above preference shares in the event of the issuer failing.

 The chart here shows the two-stage collapse of T1 bank bonds. The first slump followed the failure of Lehman Brothers last year, and the second the introduction of the 2009 Banking Act. But it also shows a small rally in recent weeks, as leading banks have come forward with offers to swap them at a discount for safer debt.

 If the worst is over, these strange animals may be less risky than the depressed prices and double-digit yields suggest.

 The 2009 legislation replaced the 2008 act, an emergency measure which gave legal cover to the takeover of distressed banks like Bradford & Bingley. The hammer-blow to T1 bond prices from the 2009 act was the provision that failing to pay the interest would not be considered a default.

 B&B bonds plunged when it appeared that there would be no further payments until the government’s emergency loan had been repaid. A clarification that the payments were up to the bank’s board stopped the rot, but the damage had been done.

 Subordinated debt is highly vulnerable should the issuer go into administration, or to forced conversion into even less secure preference shares in the event of a capital reconstruction.

  This is why B&B perpetual subordinated bonds stand on yields of nearly 40 per cent, even though all the coupons have been paid since the bank collapsed. A buyer would only need another five semi-annual payments to get his money back, but the risk is that the payments are missed and that B&B drifts into legal limbo, potentially turning the issues into worthless perpetual, zero-coupon bonds.

 Rather less risky, which is why I’ve bought some, are Northern Rock’s 12 5/8 per cent perpetual subordinated notes. At 76 they yield 16.6 per cent. On April 23 Northern Rock reported first-quarter figures and signalled that it was working on a capital reconstruction with a view to eventual return to private ownership.

 It’s impossible to say whether this is good or bad news for us Rockers.

 Perhaps a better bet are the 9 3/8 per cent perpetual subordinated bonds from the Halifax. Like the Rock stock, these are the former Permanent Interest-Bearing Shares (PIBS) which became bonds when the building societies floated. At 60, these return 15.6 per cent.

 Lloyds Banking Group, which inherited the bonds with its shotgun marriage to HBOS, cannot pay a dividend on its preference or ordinary shares without first paying the interest on the bonds. One day, it will want to do so.

 All these bonds are risky, but the gap between War Loan on a yield of 4.6 per cent and subordinated bank debt on over 15 per cent looks too wide to me.

  • About Neil

    "City Editor, The Daily Telegraph 1986-2005 City Editor, The Sunday Times, 1984-1986 City Editor, Evening Standard, 1979-1984 Director Templeton Emerging Markets Investment Trust plc, Finsbury Growth and Income Trust plc Passion: fly fishing (and wife Julia and seven-year-old twins)"
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