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Bond of the Week: 15 May 2013

Co-op bond 13% ex-PIB perpetual.

    

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)
ISIN:                      GB00B3VH4201
TDIM:                   CPBC
Coupon:                13% s.a. (January and July)
Maturity:               None (Perpetual)
Issue size:              £110 million
Denominations: £1,000
Type:                     Subordinated (upper tier 2)
Price:                      84-88 (changing frequently
Running yield: 15.48%-14.77%

So what has brought about this sudden crisis? Co-op’s failed attempt to buy the Lloyds branches (Project Verde) that had been put up for sale as part of EU state aid requirement has turned the spotlight on the mutual. Both they themselves and the regulators have been forced to shine a spotlight into areas of the balance sheet where the sun doesn’t shine. Much has been found wanting – both under provisioning for loan losses (particularly in the commercial real estate area) and also the quality of the personnel involved. Large write downs were announced in the year end Dec 2012 annual report. The bonds declined, post the 21st March announcement of losses, and there has been definitely a soggy feeling to them since – bonds looking for a home and not finding one. But price movement was limited. However, it was the recent much-publicised six notch Moody’s down grade that sent prices over the edge; an eye-popping 66 points in the case of the Co-op 13% bond (priced at 154% last week).

Why is there a problem?  Co-op had been meandering along quietly in the background throughout the financial crisis. For most of the crisis this bond (and other of their issues) traded at much higher prices than the likes of Lloyds, RBS and Barclays. It was assumed, as a mutual and as part of a wider group which had many non-banking assets, that it was somehow a safer and indeed more savoury banking option. The management themselves, failing to take a vigorous look at the asset quality of their book or (I expect) the lax lending habits unfortunately so often found at mutuals, probably believed all was going swimmingly well. They had none of this casino banking (which generally is very profitable) that Vince Cable likes to talk about. From the mutual came a warm glow of self- satisfaction and superiority as they pursued an ethical rather than a profitable approach. However, it now appears the Bob Diamond banking model is the better one for bond holders.

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.

Time and the attitude of Co-op Group and the PRA (regulator). Provided the regulator is not bounced into action in order to prove their vigour (I think this unlikely) by market comment and dire price action, I think there is time. We are not in the fast paced quick changing environment of 2008-2010 which saw action on Northern Rock, Bradford and Bingley, RBS, Lloyds, Dunfermline BS, Chelsea BS, West Bromwich BS, Kent Reliance and Newcastle. What a long list. Time is of great help. It makes a knee jerk, harsher reaction much less of a threat. Co-op does not present a systemic threat to the banking system  which as a whole is now awash with liquidity and capital.

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.

Conclusion.  Undoubtedly this bond has almost as much upside as downside in price terms even if you think the outcome is binary. Such situations as this are not gambles in the sense that they pay-out on average more than they lose. However, to buy this bond you have to have your eyes open and be prepared to take a loss. As the CEO, Gutfreund, whispers into the ears of the trader John Meriwether at the beginning of Liar’s Poker asking him to gamble all on one hand, "One hand, one million dollarsno tears.", so 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). The risk is clear. In a nutshell, if the commercial loan book is containable you should be OK. If not you won’t be. What the containable number is is unclear but I expect leniency from the regulator as a negotiable solution is found. Co-op Group will also want a consensual solution. And don’t forget nothing can be forced on the bondholders unless the regulators take hold of events. However, this does not mean a solution is necessarily possible however hard it is sought. Barclay’s, as an outlier, says the Co-op may need £1.8bn. I doubt this is the case but if it is you may need to avail yourself of the Co-operative funeral service to put this bond to rest. It is this unknowable question on the size of any black hole in the non-core book that makes it difficult for analysts to make a recommendation to buy. It also makes it easier for institutions to just sell and be seen to do their duty. This may mean an opportunity in an oversold market. What am I doing? I had a small nibble at 105 1/4 and am slightly underwater. At the moment I am striding up and down outside the casino swing doors, spurs on my boots and bootlace tie round my neck, biding my time. I expect it is when rather than if before I return to the table. I feel it would be rude not to attempt to make a profit from trading in the bonds of people who do not approve of profit.

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.

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

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