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Bond of the Week: 28 October 2013
Bond of the Week : 28 October 2013
In the prolonged absence of a new issue for the ORB market I present something completely different. I normally leave others to write Bond of the Week on non-new-issue weeks but I thought I would present the below just because it is very different. It is an issue that might not suit everyone’s portfolio but I think it at least raises interesting ideas. In truth it is not even a bond but a preference share.
Here it is:
Before looking at the reasons to buy this issue, here is a look at the credit. Investec is the fourth largest South African Bank and has many of the characteristics of a wealth manager/ investment bank. What is important to understand is the structure of the bank. If you buy a share in Investec you buy an equal entitlement to the profits of the South African business (Investec Ltd) and to the profits of the international part of the business based in London (Investec PLC). However, there is no overall holding company. The two businesses act as sisters but neither one has any lien over the assets of the other. This type of structure, separating ownership of the domestic from the foreign assets, has been used by other South African business when they have wished to expand abroad. It is not difficult to work out the reason for this.
For the sake of form, this is how Investec describes their structure (DLC = Dual Listed Company): “A DLC structure is an arrangement by which two separately listed legal entities are combined into a single economic enterprise through contractual arrangements and provisions in the constitutions of the two entities. Shareholders effectively have economic and voting rights as if they held shares in a single company.”.
This preference share, however, is issued (as with most Investec bonds) by Investec PLC alone and so is only the responsibility of the international arm of Investec. You are not directly reliant on the performance of the South African bank itself. Fitch and Moody’s rate the senior obligations of the PLC at BBB- (the lowest investment grade rating). This issue, which is a much more junior obligation, is not rated. The March 2013 annual report shows the following figures: Tier 1 capital of 11% (about in line with UK banks), profit up to £122million from £94million in March 2012, a very high level of liquidity (£4.6bn) representing 33% of total liabilities and total shareholder equity of £2.26bn. As you would expect of a bank that describes itself as “an international specialist bank and asset manager” which “lends to high net worth and high income individuals, mid to large sized corporates, public sector bodies and institutions”. (bearing many of the characteristics of a Swiss bank) it is run on a conservative basis. Like many banks, particularly those with large wealth management departments, the recent objective has been fee income and a “successful strategic alignment of the group towards low capital intensive businesses over the last couple of years”.
As perpetual preference shares there are very substantial differences between this offering and a standard ORB bond. As well as looking at Investec PLC the company, you have to look carefully at the actual terms of the structure of the offering in order to assess the credit risk you will be undertaking. The prospectus of the deal is admirably clear and concise compared with newer bank capital offerings. The prospectus states “The perpetual preference shares are non-redeemable, non-cumulative and non-participating”. In other words the shares have no maturity date, are not cumulative if a payment is missed and you have no right to vote at a shareholders meeting even if the dividend has not been paid. As to the dividend the prospectus simply states: “An ordinary dividend will not be declared by Investec plc unless the preference share dividend is declared”. In other words Investec is not obliged to declare (ie pay) the dividend (coupon) on this preference share but if they do not pay then ordinary shareholders will not receive a dividend. However, I expect for reputational reasons that Investec will always pay the dividend if they are able to do so. Prior to the financial crisis and the EU ordering Lloyds and RBS not to pay dividends on their preference shares, I believe baring Barings, no British bank had failed to pay a preference share dividend since the early 20th Century.
A final and positive point on the structure of this preference share is that as a share the dividends are paid out of the post taxed income of Investec so they bear a tax credit. For basic rate tax payers or for companies (which have a profit below £300,000) there is no tax to pay on the dividends (which should more or less equate to an uplift on the coupon of 20%).
Lastly how did Investec weather the financial storm starting in 2007? ; in a word well. They did have some impaired loans to property developers but nevertheless managed to stay profitable throughout the crisis. They required no governmental support (they are counted as a systemically important bank in South Africa so a helping hand would presumably have been there for at least Investec Ltd). They also maintained dividends on both the ordinary and preference shares throughout. Finally their investor relations department have told me they have no exposure to peripheral Europe.
So how would I summarise the credit? It is neither the best of credits nor the worst of credits. In practice though it is a conservatively run bank (lots of liquidity), that is acutely conscious of the risks of the waters in which it swims and it has had a successful passage through the stormy waters of the financial crisis. Therefore if the price is right on a bond/ preference share then the credit risk is good enough for me. I also think the tax advantages of owning a preference share outweigh the disadvantages of the subordination to senior debt.
Now to the reason for buying the issue; it is a simple argument. The preference share is a discounted Floating Rate Note and therefore offers protection (profit) against a rise in interest rates. It is easily explained by the table below: As a floating rate note you are protected against a rise in interest rates as the dividend will always reflect current short term rates. As the price is at a discount there is a gearing effect and the higher rates go the higher is your coupon by a factor of 2 ¼ (£10/ £2.25). The running yield calculation is really quite simple. At the current fixing it is 1.5% X £10/£4.45 = 3.37%. With 8% base rates, for example, it is 9% X £10/£4.45 = 20.22%. This bond will therefore provide a good hedge against a rise in interest rates. Your yield will increase and this should produce a capital profit just as the capital value of other holdings may be in decline.
Conclusion. I have wanted to mention this pref share for some time but did not do so – in part because I was not engaged to write on such issues but also because there has been a problem of supply for a long time and I wanted to write it up when I knew a reasonable amount was around. There is only one market maker (Canaccord, who was also the lead manager of the issue). A week or so ago they told me a block had finally become available and I decided to write the issue up for Bond of the Week. However, an offering email went out the same day and the shares were gone in an afternoon, the price ticking up. From that I think it is not only I who has concluded the story is compelling. Nevertheless the very rapid placement of the block represents a problem; I may never find a time when I can write up the issue confidently knowing there is a good supply of the shares available. [I note here the size of the market quote is 1,500 which equates at the current price to an investment of £6.675]. However, I am writing it up now as I think it is fair to say that barring any change in Investec’s credit, the price of the shares are only going one way; it is just a question of the speed with which they get there. Of course there is the question of when rates will rise. I have, for a very long time, been of the opinion that any rates rise was a long way off. Today it is finally possible to start to perceive economic developments that may lead to a rise in the medium term future. I could of course be wrong and rates might rise sooner and faster. Don’t forget you should partly be buying this issue as a hedge I/ we/ the market is wrong. I also think others will be buying this preference share, so even without an imminent rise in rates a capital profit of some sort is likely. By the time it is clear a rate rise is about to happen, the ability to make a purchase at anywhere near the current price will be history. If you like the story hesitation is not a good idea.
Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.
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