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Bond of the Week: 1 August 2013

Co-op 13% - a revisit...

    

In the absence of any new issue retail bond, I think I should revisit a bond I covered on 15th May on Bond of the Week  - the Co-op 13% (and by inference Co-op 5.5555% and Co-op 9.25% pref shares). It is certainly the most interesting situation around at the moment.

Since my comments in May the price of the 13% issue is down substantially to around 57 mid-price and the coupon has been suspended (not cancelled as some have claimed).  However, all still remains to play for as an offer is awaited from the Co-op. There has been a lot of discussion of the issues surrounding these bonds in the press, albeit of a general nature and where journalists have been responding to story lines/ pressure first from the Co-op side (painting a most gloomy picture) and then from the resistance group of retail bond holders. There has also been a great deal of analysis and comment on the internet – much of it excellent and detailed. If you would like to look further into the campaign being waged by Mark Taber on behalf of retail investors, may I suggest this link? Given all the comment I limit myself to what to expect next and what in all probability your choices will be.

The next news flow should come at the end of August when the Co-op announces interim results. These will be interesting as the bank is likely to show large losses. In the 2012 annual report the bank had £1.85bn of equity capital and Barry Tootle CEO reported “The Bank’s underlying financial strength remains intact”. A few months afterwards and following stress tests and consultation with the PRA (formerly the FSA) the bank has announced they need £1.5bn extra equity. Bear in mind stress tests do not deal with actual losses but what could happen in the future under certain scenarios. However, the Co-op Group as part of its campaign to make the bondholders contribute has declared it has already lost all its equity in the bank. Given as things stand with equity of £1.85 bn this is patently not true will they attempt to square the circle by declaring a loss of around £1.5bn in August extinguishing their equity? I suspect a large loss but have no idea if they will dare to go this far.

If the Co-op does declare a loss approaching £1.5bn they present themselves (and their auditors and the PRA) with another problem. How could such a large hole suddenly appear in the balance sheet on historic items in the absence of any cataclysmic event in the economy? Indeed I was told by a well informed source that building societies and banks should be making money hand over fist in 2013 as the Funding for Lending Scheme has suppressed savings rates thereby increasing the crucial net interest income margin. If the Co-op were to declare a loss that in effect wiped out all their capital they would match what happened to RBS in 2008. However, RBS faced a ferocious and totally unexpected financial storm and the bank lost its capital because a) they had to write off goodwill from the purchase of ABN Amro and b) mark to market losses in the investment bank’s trading positions. Co-op has no goodwill it must write off and no investment bank and has had 5 years to acquaint itself with the new economic reality.

I would therefore suggest a loss of anything approaching the level needed to justify the Co-op Group’s contention that it has lost all its equity should result in a visit by the SFO. The only alternative to their having been gross accounting negligence is an even worse alternative. That is that there is a Machiavellian but all too believable plot by the PRA and Co-op Group to deliberately exaggerate losses in order to make bondholders pay and thereby do obeisance to current received wisdom. Whatever the outcome, the August figures are likely to substantially affect bond prices.

At some point (October/ November?) the Co-op will make an offer to holders of the retail bonds. However, it will be a voluntary offer. Never forget that in the absence of the use of the 2009 Banking Act’s Special Resolution Regime you do not have to accept what is offered. I emphasise this as I find many people and even institutions tend lemming like to have an urge to throw themselves at a tender offer whatever it is - almost as if that is automatically the right thing to do.

Nevertheless there is no doubt the majority of bondholders will have to accept something if the Co-op is to find the capital – it is just that you do not necessarily have to be part of that majority. Don’t forget that institutional holders of the senior subordinated bonds (£950 mil out of the total £1.3bn subordinated bond total) will be in intense behind the scenes negotiations with the Group and it is ultimately in both their interests to reach an agreement. Therefore whether or not you accept what is offered will not determine a successful outcome for the recapitalisation of the bank.

At this stage it would be ridiculous to make a recommendation on what you should do in response to an unknown offer to be made at some time in the future. However, I would make the following observations. Following a successful recapitalisation should the three retail bonds still be in existence they will almost certainly have their coupons restored and you have to assume they will trade at similar yields to other perpetual bank and building society bonds (9% and slightly lower for the pref?). Therefore will any offer the Co-op makes be superior to the future price of the bonds/ pref post a recapitalisation? On the 13% and 9.25% pref I think not. Co-op cannot make a tender offer higher than par or they would end up losing not gaining capital. To make any sense they will have to tender below par whereas the future prices should be above par. On the 5.5555% it may be a different story. The coupon is lower, it refixes to a not very attractive Libor+2.05% in 2015 and the pre-crisis trading level was much lower. It may therefore be possible that there is a deal to be done that will satisfy both sides.

Conclusion. We are set for some volatile trading when the Co-op announces their results and it is quite possible the prices will get frightened further down. When an offer from Co-op Group does come, it is unlikely in the case of the 13% and 9.25% pref that you will want to accept. If that is the case put your own interest first and do not accept. This piece is primarily addressed to holders, as Co-op bonds are very widely held. However, the logic of the situation also applies to potential buyers. Essentially the gamble is will a deal be struck between the institutional bond holders and Co-op Group (with some take up by retail bonds, in particular the 5.5555%) which will give the bank sufficient capital but allow you to slip through the net and sail on into the future with your fat coupons restored? Or will there be a failure to agree so that the PRA takes over using the Banking Act?  I suspect an agreement will be found as it suits all parties to find it and at worst you will be offered something that is at a slight premium to today’s prices. Therefore I have averaged down. There is a lot of potential upside in these bonds but you are facing unknowably bad results in August when prices may dip and an uncertain offer in the Autumn. Therefore I believe prices are trading at a discount to the probable outcome. However, that does not mean it cannot go horribly wrong if the various interested parties squabble and fail to agree. It is a punt and if you do make a purchase remember what I said last time: “if you decide to make a purchase and it goes wrong there should be no tears, no self-recrimination or recrimination of others (especially me).”

Oliver Butt

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income.

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