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Bond of the Week: 15 May 2013
Bond of the Week : 15 May 2013
Just when you are sitting back in your chair thinking there are no interesting bonds left, just as you watch the blossom burst forth through the window and think all is done for the summer, along comes Co-op Bank to offer you an opportunity. But should you take it?
Much has been written in the papers about bank bail-ins, subordinated bond burden sharing and other modern buzz words that are designed to frighten the children. The press will never underplay a news story. Writing about a murder in Limehouse they scream “Gory Murder. Read all abaht it” and so we get horror stories about what will happen to bond holders in the financial pages. I do not underestimate the risks associated with Co-op but there is rather a lot of loose talk about how and why the worst might happen. Therefore below, without pretending to have done any in-depth analysis of the balance sheet is, I hope, a logical guide to where we are. The bond, is a traditional retail bond with a very simple structure, I use by way of example:
Issuer: Co-operative Bank PLC (formerly Britannia BS)
What is the problem? What can kill a bank stone dead in a very short period is a liquidity run (Northern Rock with depositors and Bradford and Bingley in the wholesale market). Co-op has a very large and secure depositor base (all guaranteed up to £80,000) so this is not a large risk. The issue for the mutual is firstly the loss in the commercial mortgage book. A large provision of £351 million in the non-core book has been made but is this just the start? Certainly there will be more but nobody knows the extent at the moment or indeed the willingness of the regulator to allow provisions to slowly emerge so that they can be covered by operating profits. The other lending books are reasonable if not of the highest quality.
The second issue is low profitability which makes the bank of less interest to outsiders who might contemplate an equity investment. Low profitability also means less money to cover the provisioning losses. However, profitability can in part be addressed by reducing costs. Nearly all banks have addressed cost issues (by getting rid of staff) but the Co-op has not. I am afraid an unethical approach beckons.
Finally and most importantly there is the problem of lack of capital and how they are going to raise it. Core Tier 1 is 8.8% which is very low compared with other financial institutions (Lloyds at 12.5% for instance). Both figures will be re-stated and decrease under incoming Basle III regulations and the Co-op will be below the minimum threshold of 7%. And that is before additional probable losses. Therefore more capital will be needed. As a mutual where is it to come from you?
Possible sources of capital. 1) Assets can and will be sold. Around £200 million is to be raised by the sale of the life insurance business to Royal London Asset Management and £200- £600 million from the general insurance business. This is a help but more will be needed. 2) Closure and sale of business lines will release capital to improve ratios. 3) A contribution from Co-op Group. There has been much speculation about this. I would suggest they are likely to come up with any shortfall so long as it does not threaten their other businesses. What the sum is that might prove too large is far from clear. 4) Outside investors could be persuaded to make an equity-like investment in the mutual but this would probably only come about with harsh cost cutting measures. 5) Government money. It is not very likely but is I suppose possible that the government could find some way of supplying capital which stops short of nationalisation (as they did with RBS and Lloyds). 6) Contributions from subordinated bond holders. (See below). 7) The bank could be sold. In the present environment, as evidenced by the failure of Project Verde to find a buyer for Lloyds branches, I see this as unlikely. 8) The Bank of England seizes the bank. In this case we can expect the quality of mercy to be very strained. At best (as with Northern Rock and Bradford and Bingley) you would be waiting for the excess proceeds from a successful run-off .
Bond holder contributions. There is currently no legal way to force bond holders to contribute to capital provided the bank is not seized under 2009 banking resolution laws. This point should be emphasised. The bank or the PRA cannot just decide they fancy some of bond holders’ money and like a bear with a honeypot dip their paw in. The Lower Tier 2 bonds have mandatory coupon payments (not the 13%) so even non-payment of a coupon is an event of default. The capital of all bonds is protected. Therefore any bond holder contribution will come about in two ways. 1) By direct government order, presumably following nationalisation, and at that stage the Co-op bank will no longer belong to the Co-op. 2) By negotiation with bond holders. This can happen by way of a proposal to offer bond holders an inducement (higher coupon?) to swap into a different instrument. It can also happen, in extremis, by frog marching institutional investors into a room and telling them to accept a proposal (haircut, worse terms on the bond etc.) or else. This has happened in the cases of Chelsea, West Bromwich and Newcastle Building Societies. I note here that although the Co-op 13% ranks below Lower Tier 2 issues it has the advantage it is a retail bond so the issuer will not know the holders and will potentially behave more sensitively. Therefore in the case of any strong arm tactics it could duck the firing squad.
Particular aspects of Co-op 13%. This bond is an Upper Tier 2 (UT2) bond and as such ranks behind the majority of Co-op’s subordinated debt which is Lower Tier 2 (LT2). LT2 bonds have mandatory coupons, UT2 bonds do not. Therefore the coupon of the 13% can be omitted at the option of the board of directors should all company dividends also be suspended. It is nevertheless cumulative. In the event of liquidation this bond will be paid after the LT2 debt has been paid off in full. I would expect, however, that in a liquidation, as opposed to an orderly run off, that there wold be no pay off for any subordinated creditors.
However, there are two additional points. A) Ranking below the 13% issue is a 9.25% pref. The terms of the pref are that if the dividend is not paid then a payment in kind of four thirds of additional pref shares must be made. i.e. if they do not pay £1 million pounds of cash they must pay the equivalent of £1.333+million of prefs. This is likely to make Co-op very reluctant to miss payments on the prefs and a pref payment will push a payment on the 13% bond.
B) In the prospectus of the 13% bond under “4.3 No deferral of interest on change of regulatory treatment" it states : “The Issuer agrees that it will not, in the event …the Bonds .. would no longer be eligible to form part of the Issuer's capital resources … exercise its right under Condition 4.2 to defer payment of interest accrued in any Interest Period”. As of next year if Basle III starts on time, this bond will at a rate of 10% per annum cease to count as capital. It should start with only 80% of the issue counting towards regulatory capital. I therefore take it that in part or in whole from 2014 the interest on this bond will be mandatory.
In short, I do not think there may be a great or any difference in fate between this bond and higher ranking subordinated bonds.
Neither the Co-op nor the government will want to bring about emergency action. To lose the bank, especially as they have been offering themselves as the gentle face of banking and promising to provide more high-street competition, would put egg all over the face of Co-op Group. It would, I assume, also go against the ethos of mutual support between different parts of the group. From the government side the last thing they need is another banking intervention just as they seem to have got Lloyds and RBS fixed. In the case of the Co-op there is not even the political merit in being seen to bash the bankers. This suggests a tendency to leniency and a negotiated solution and that there will be no urgency in finding a solution.
Price action. Subordinated bond price action is poor. Prices have not bounced post the collapse at the time of the Moody’s announcement. Instead they have drifted. I expect this to continue. However, there are two things to consider. A) The yield is already more than handsome and as an investor you should decide whether you think the return is appropriate for any risk you might wish to take. The direction of market prices is important but as a friend of mine always says, picking bottoms is for monkeys. B) What is the reason for the price action? The sellers have been both institutional not retail. I suspect institutional sellers have not made an attempt to arrive at a risk reward payoff to determine a price at which they may sell or add to their position. For the most part they can simply do without the headache as Co-op is not a major borrow. Therefore they sell at market. At the same time retail investors are probably motivated by headlines in the financial press (as mentioned in my first paragraph). For this reason I would expect prices in the very near term to be weak, although when and if the bounce comes it will be large.
PS. I realise many of you may already be holders of Co-op 13% and this article is addressed to would be buyers. However, although it may be hard, you should always attempt to look forward not backwards with investments. Excepting tax considerations, cost of an investment should not enter into deciding what you do now.
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