Business | Investment
Bonds: Buy now while stocks don't last
Newly released British financial instruments weigh in as the new equity in cash-starved industry.
- By Sean Kelleher, Special to Gulf News
- Published: 22:40 December 20, 2008
British Bonds have never been so exciting since Daniel Craig launched his 007 career in Casino Royale. Whilst James Bond might be dashing and dependable amidst turmoil and turbulence, he is ultimately fictitious.
Not so with the new releases of British bank bonds, these are Real-McCoy opportunities, dashing and dependable (with some risk); but what you can make out of bank bonds smashes the 007 mark. Here are the headlines: major investment grade (not your junk risk) is being issued at 50 per cent to 90 per cent of the face value.
Significant discounts together with a definitive maturity date and yearly yields of around five per cent or 20 per cent lifetime yields. In these obviously turbulent times what else looks so dashing and dependable outside of the fictitious world?
The background story is, of course, very real-world. The near-collapse of the banking system and the white-knight reactions of governments to save banking; add in the sub-plot of collapsed equity valuations together with the appetite of white knights for debt instruments and you have the full backdrop. It's this sub-plot that opens up the opportunity: the debt versus equity contrast.
Let's start with bank equity. According to RMB Asset Managers, one year ago Royal Bank of Scotland, as part of a consortium, paid $100 billion (Dh367 billion) for ABN Amro - with 80 per cent of that in cash. For this amount today you could buy: Citibank ($22.5 billion); Morgan Stanley ($10.5 billion); Goldman Sachs ($21 billion); Merrill Lynch ($12.3 billion); Deutsche Bank ($13 billion) and Barclays ($12.7 billion), and still have $8 billion in change for festive shopping - but not at Woolworth's. The times have changed, and a shareholding in a Bank is not what it used to be.
As far as British banks are concerned, the banking sector had accounted for around 32 per cent of the FTSE income and had been one of the more dependable sources of dividend yields. They were mainstay equity choices in both growth orientated and income producing portfolios. Now of course, their struggle for survival puts them in an equity sector that has declined over 50 per cent, meaning that a recovery of over 100 per cent is required to bring any comfort to equity holders of bank stock.
The crashing value of bank equity is one thing. There are two other standout issues that British banks need to grapple with before investors would gain confidence in equity prices. Firstly, government intervention and rescuing of some banks included the ruling that dividends can not be declared before preferred debt has been repaid in rescued banks. While the ruling does not apply to un-rescued banks it remains a drag on the banking sector.
The second issue is the apparent collapse of the funding model. Banks are supposed to get money from one source and lend to another. Simple, although it got complex - but the good news is that it has got simple again. There are three general sources of money. Equity capital, the cheapest source as there is no cash flow cost. For British banks, a dried-up source until the model gets sorted out.
Then you have deposits - the new gold dust for banks. Then you have the inter-bank markets. This latter market seems to be the key. All eyes are on "the spreads" which collectively ask the question: do banks wish to lend to each other?
The answer as at now is a resounding "no". Inter-bank distrust remains at all-time highs. The massive liquidity conundrum remains unsolved.
Compelling
The equity backdrop and the need for banks to find cash makes current bank bond offerings very compelling.
As Peter Smart of Brewin Dolphin in London asks: "are bonds the new equity?"
A quick browse of some of the bank bond offerings show the current list of five significant benefits: firstly, discounts to maturity of around 50 per cent to 90 per cent; secondly, unlike the "vagueness" of equity maturities, bonds have a definitive maturity date; thirdly, yields can be found at around 20 per cent lifetime yield, way above normal for debt; fourthly, the current interest rate environment is likely to remain low with debt and cash rates set to fall; and finally, these bonds will be issued in what Smart calls a "no quibble government environment", the interests of government and tax-payers will be aligned with bond buyers. Strong friends for bond-buyers.
The risks? Like all debt the risk is default. Will your bank default? Two considerations here: on the one hand credit default insurance suggests that default probabilities remain unusually high. British banks lag behind the risks associated with the high-probability default areas such as Argentina and Iceland, however, the probability of default readings from insurance rates are still poor in historical terms.
On the other hand, high returns come from perceived or real risk. In this instance, investors will take the bond yield purely because they can't see the government letting too many banks fail. They will make the "assumption" that either it will all sort itself out - in which case the bond returns are excellent; or, there will be no real solution, and problems will be bigger than a default on bond investments!
- The writer is Chairman of Financial Partners and Mondial
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