How to make 16.9% a year from the Co-op

• Since Moody’s downgraded the Co-op Bank in May 2013, Bengt has updated his view. Read what he has to say here.

I’ve talked a lot about bonds here at The Right Side recently. And it’s great to hear that more and more readers are switching on to the opportunity in bonds.

If you’ve not got the basics yet, I recommend you read my articles here and here and Tim Bennett’s 11-minute video tutorial here

If you’re up to speed and itching for a great bond to consider, then keep reading…

Today I want to introduce you to the Co-operative Bank 5.5555% perpetual subordinated bond. As I’ll explain it’s actually paying much more than that 5.5% headline rate… something you’re not likely to know unless you’re used to these things.

As you’ll see, this one has some great features that not only offer some tantalising opportunities, but also allow me to explain a few more nuances about bonds – and how they differ from shares.

First things first…

Why I’m happy to lend to the Co-op

A bond is a loan. It’s fundamentally different to equity (which is literally a stake in the business). And when you make a loan, you want to be pretty confident about who you’re lending to and on what terms.

Now, this bond was issued by the Co-operative Bank – which is itself owned by the Co-operative Group. I’m sure you’re familiar with them. They’ve got supermarkets, pharmacies, travel agencies and undertakers, all operating under the Co-operative umbrella.

As a mutual, there are no shareholders. The upside to that is it’s pretty conservatively run. This is not run by the sorts of guys that jumped on the ‘de-mutualisation’ band wagon and ran up risky bets for the former building societies. You know – the Northern Rocks and Bradford & Bingleys of this world.

The downside of not having shareholders is that there’s nobody to put their hand in their pocket if the society does hit the rocks. But overall, I’m not too concerned about that. The fact that this group has diversified earnings and is run on a mutual (and they say ethical) basis, is all positive for me.

Personally, I’d be happy to lend to them.

But then there are the terms…

I’ve just been on the Co-op Bank’s website. Like most other banks they offer pretty much close to nothing on savings. A so-called ‘Smartsaver’ can achieve 0.25% p.a. Step up to the ‘Privilege’ bracket and you can get… wait for it… 1% – wow!

If you want anything approaching what I’d call a non-offensive return, then you need to lock your money up – we’re talking between one and three years to get between 3% and 3.75%.

Well, I don’t want to lend my money to the Co-op at those sorts of rates and on those terms. Not when there’s an alternative…

This is where things get very interesting

The Co-op bond I want to talk about has a nominal interest rate of 5.5555%, but in reality I’m looking to get much more than that.

This issue was originally launched back in the 1990s by the Britannia building society. But in 2009 Britannia was taken over by the Co-op and the bond was rebranded as offered by the Co-operative Bank.

Now when Britannia came to the market looking for cash, the financial world was a more normal place – especially when you’re talking about interest rates. Britannia launched the bonds with a rate of 5.5555% in perpetuity (ie, forever).

Now, of course, most lenders weren’t prepared to peg onto a fixed interest rate forever, so Britannia put in a rate ‘re-set’ at December 2015.

At this point (three and a half years from now), the interest rate will be reset to three-month LIBOR (the average rate that leading banks in London charge for lending to each other) PLUS 2.05%. And the Co-op will have the option of redeeming the bond.

That was meant to be a penal rate of interest – ie, it was considered harsh enough to ensure that Britannia paid off the loan. But, of course, in today’s interest rate environment (ie, where there’s practically no interest on cash), then 2% above Libor is okay for the Co-op.

Basically, come the end of 2015, Co-op may choose not to pay-off (redeem) the bond. It could let it run at LIBOR plus 2.05% (with the LIBOR rate used to re-set interest on a quarterly basis).

Well, either way, I don’t really care. I figure this bond makes a lot of sense.

This bond could pay me 16.9% p.a!

This bond was launched at £1 (par) offering initial investors a coupon of 5.5555p p.a. up until 2015. Yet today I can buy this bond for about 68.5p.

That means the interest on the bond is no longer 5.5555% (5.5555/100), it’s a much more satisfactory 8.1% (5.5555/68.5) for current investors.

But we know that the Co-op can redeem the bond in three and a half years-time. Now that would be even better for new investors. Let me explain…

Not only would I receive an 8.1% interest rate between now and 2015, I’ll also get paid back £1 on every bond I’ve bought at 68.5p (that’s a near 50% capital gain!)

I’ve just done the maths. If I add the capital gain to the running yield, I get a gross redemption yield (GRY) of 16.9% p.a.

Now that would be fantastic wouldn’t it?

But remember, it’s up to the Co-op if they want to redeem the bond. So let’s look at the alternative…

How I can get an inbuilt inflation hedge for my money

I think we’d all love a 16.9% a year return over the next three and a half years. Frankly, the only thing that would make this sort of return look bad would be if inflation and interest rates suddenly ratchet up. Though I’d hate to imagine what the world would look like if rates really rise to anything like 15%!

Now I know lots of people are dismissive of bonds because they’re worried about rising rates. That’s a very real and valid point. If interest rates go up, bonds tend to fall.

But what I’ve got with this bond is an in-built inflation hedge. If the Co-op chooses not to redeem the bond, then I’m set to receive 2% above the rate banks lend to each other (Libor). I’ll effectively be on a LIBOR tracker (the rate being re-set every quarter).

Remember though, I’m not paying full whack for this bond. I’d be picking it up for 68.5p. So the rate will be even better for me.

Let’s say rates have gone up (a bit) come December 2015, and LIBOR is 2%. That would mean the nominal rate on the bond would be 4.05% (2% + 2.05%).

But the effective interest rate is nearly 6% (4.05/68.5= 5.91%)

If rates shoot up, I do even better. Because we’re getting the bond way below par, we’ve got a leveraged return on the interest rate.

And though the bond could theoretically go on forever, it doesn’t mean my relationship with it has to. Unlike those nuisance offerings from the bank that get you to tie your cash up for years in order to get a decent rate, with a bond I can sell it whenever I like (just like I could with a share). And I can do it with NO interest penalty.

So the way I see it, this bond offers some options not normally open to me and could be great as part of a diversified portfolio. The lure of a decent fixed income (in these return-free times) and yet, an in-built inflation hedge that kicks-in at the end of 2015.

And to top it all, I’ve got a potential bonanza should the bonds be redeemed in 2015!

Sounds good, right? But what risks do I need to consider?

This is nowhere near as safe as a savings account

Well, first of all I’m aware that these are subordinated bonds – that means they’re lower down the pecking order than other creditors if the Co-op went bust. This bond offers no security. Other bonds I’ve shown you in the past have charges over things like property (Enterprise Inns).

That means that with this bond I am totally dependent on the solvency of Co-op Group. I’ve outlined my reasons why I’m comfortable with that.

But if the group hits tough times, then it has the right to stop paying interest on the bond without making it a ‘default’ event. This is one of the main risks of holding subordinate (or junior) debt. Basically, in terms of bondholders, ‘subs’ are the lowest of the low!

There are some contractual reasons (mainly to do with tax and regulation) why this bond could be redeemed early. But given that I’d be buying these bonds way under their par value, an early redemption would actually mean I cash in a fat capital gain.

And one final thing I always bear in mind when I’m considering investing in bonds is this. Bonds aren’t covered by the Financial Services Compensation Scheme (FSCS). In other words, unlike money in a deposit account, my money is not covered if the Co-op goes down. And because they’re quoted on the markets, the price can (and will) change. This is not the same as having cash in the bank!

Well, I hope that’s given you something to think about. What I’m trying to do here is show you how you can use bonds to diversify your portfolio and savings. When I see something I like the look of, I’ll tell you about it so you can check it out more for yourself.

To find out more about the Co-operative Bank 5.5555% perpetual subordinated bond and download a prospectus, visit the London Stock Exchange website.

• Since Moody’s downgraded the Co-op Bank in May 2013, Bengt has updated his view. Read what he has to say here.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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47 Responses

  1. 22/06/2012, Barney wrote

    Hi there,
    The above looks very interesting,but my broker TDW does not appear to sell this Bond. Can someone rec one that covers nearly all Bonds & give a good service.

    Regards,

    Barney

  2. 22/06/2012, bengt wrote

    I’m pretty sure Barclays stockbrokers will trade these bonds. They are the biggest UK private client broker and they say they’re into ‘retail bonds’

    bengt

  3. 22/06/2012, Barney wrote

    Hi bengt,

    I’ve had a look at Barclays and could not find the bond in question plus they appear to be expensive, £30 min for a Bond plus other charges if it’s in an ISA. I will carry on looking.

    Barney

  4. 22/06/2012, Seth wrote

    Hello Bengt,

    Would a change in the coupon from 5.55% to 4.05% a reduction
    of 27% not having a commensurate effect on the trading price of the bond whatever that may be at the time.

    Have I figured this correctly or does the switch to the LIBOR rate + 2.05% change the risk profile of this instrument in some way? If not then am I right in concluding a reduction in the coupon would result in a commensurate reduction of the bonds trading price?

    So the will the co-op redeem or will they switch it to LIBOR +2.05%?

    The issue size on this is £200 million. I guess the state of the co-op’s balance sheet in 3.5 years time along with the prevailing LIBOR rate will dictate whether or not they will stump up the £200 million or let the bond continue.

    Thanks for reading this and hope that I am making some kind of sense. Any response you care to make would be appreciated.

    Regards,

    Seth

  5. 22/06/2012, SteveH wrote

    sippdeal do it
    ISIN GB00B3VMBW45
    (Note to Bengt, the Isin or SEDOL would always be helpful)

  6. 23/06/2012, Margaret wrote

    I follow your bond news with great interest and have invested in the Enterprise Inns bond. Do we know if the Co-op Bank is free of dodgy loans to Europe?

  7. 23/06/2012, Doug wrote

    Hi Bengt, I am very new to all this and am trying to invest via my ISA. Can this Co-Op bond and others be put into my stocks & shares ISA ( which is with FIDELITY) without problems?

    Thanks

  8. 23/06/2012, bengt wrote

    Margaret,

    Good question – this from their 2011 accounts:

    Credit risk continued
    1.5 Eurozone risk
    The Bank remains a low risk UK based operation. It has no sovereign exposure to ‘peripheral’ eurozone countries (Portugal, Ireland, Italy, Greece and Spain).
    As at 31 December 2011 the Bank had a £90m (2010: £nil) exposure to the Government of Finland, repayable in over one year. It held no other European sovereign debt.

    Regards

    bengt

  9. 23/06/2012, bengt wrote

    Doug,

    Yes, these bonds are for ‘stocks & shares ISA’s’ which is great, as you can put away twice as much tax free as a cash ISA.

    I suspect the ISA you’ve got with fidelity is one aimed at ‘their’ products… but you’ll have to ask them.

    But you can transfer ISAs to other providers (like a stockbroker that can trade these bonds), or if you haven’t started this year’s ISA yet, then why not start a new ISA with a broker that trades retail bonds?

    Bengt

  10. 23/06/2012, bengt wrote

    Seth

    To my mind, the price of the bond reflects the fact that in 3.5yrs time the bond will become a libor tracker, and in the meantime investors will get a running yield of over 8%.

    what I’m saying is, the market isn’t really expecting the bond to be redeemed. So in that sense, I wouldn’t expect the price to fall too much if there’s no redemption. Clearly it wall fall a bit… as the potential capital gain kicker will be firmly kicked into touch.

    But I think there’s a 50/50 chance of redemption. As my calculations show, that would be a fantastic investment for buyers today. If it remains a libor tracker, then that’s okay too.

    Bengt

  11. 23/06/2012, Donny wrote

    The London stock exchange site says the co-op bond is redeemable in 2099. Where does the 2015 date come from?

  12. 23/06/2012, bengt wrote

    Donny

    The stock exchange’s site always puts a 2099 redemption date on bonds in perpetuity.

    You’ll have to look at the prospectus if you want to read all the legal speak on how and when the bond can be redeemed.

    But the most important thing in the prospectus relates to the interest rate reset and early redemption (end of Dec 2015)

    bengt

  13. 23/06/2012, Tony wrote

    I am with the coop bank but they do not no what this bond is,have you any idea where to buy these bonds

  14. 24/06/2012, Gary wrote

    I’d be very careful on selecting this as a medium or long term investment. Current 3 months LIBOR is around 0.47% and has been much lower in the recent past. Unless there is a significant increase by 2015 (unlikely in my opinion) you would be stuck with an interest rate of 2.5% (equivalent to 3.6% assuming you buy the bond at current price). With this level of interest rate, Co-op would not redeem so you’ld be truly stuck with the bond. Of course, you could sell it but the price is likely to fall well below the current price given the interest rate scenario. The longer term potential risks on this bond far outweigh the short term gains I would say. As usual, if something seems too good to be true – it usually is!

  15. 25/06/2012, dlp6666 wrote

    Fair point, Gary – and it would be a shame not to bag that nice capital gain.
    But I don’t think you’d be ‘stuck’ for ever with the low interest rate that you quote if Co-op decided not to redeem, as the rate is reset every quarter.
    So if rates go up (as eventually they must, even if not by 2015), you’ve got a guaranteed 2.05% + LIBOR, which isn’t too bad, especially if inflation takes off …

  16. 26/06/2012, Gary wrote

    dlp6666 – I agree with you that interest rates must eventually go up. The problem I have is that it could be very far in the future. We’ve been stuck on a BoE base rate of 0.5% for over 3 years now and there’s no sign it will go up at all any time soon. Also, historically Libor tends to be well below BoE base rate so the 2% Libor Bengt uses in his example is a long way off.

    A spell of rampant inflation is what we need! …

  17. 26/06/2012, Derek wrote

    What about the risk that the co-op bank will overreach itself by taking on the Loyds TSB branches ?

  18. 26/06/2012, Mark Senior wrote

    Bengt,

    Tough to buy this at 68. 5p, I had to pay 71.8 today(26th)

    Good news is that i bought via Share centre where my dealing charge is £7.50

    Keep sending out the ideas!

    Kind regards

    Mark

  19. 26/06/2012, Isaman wrote

    Selftrade have it along with a huge selection of bonds. But I left them after I found their admin hopeless.

  20. 26/06/2012, dlp6666 wrote

    Hargreaves Lansdown charge £20 (can only buy this bond over the phone), but I’ve found that their customer service is really tremendous.

    But I’m going to try and wait till the price falls a little.

    By the way – the Prospectus refers to the 2.05% margin being on top of 3-month LIBOR (not the overnight rate).

    3-month LIBOR is currently 0.90%, so that improves the longer term potential a bit if Co-op do decide not to redeem in 2015

  21. 27/06/2012, mike wrote

    building on the comments from Gary, i can see the price of this bond reducing down from 68.5 as we approach 2015, with the possibility/likelihood that by the relevant date in 2015 you will be sitting on a paper capital loss that would not be offset by the interest you have received, and given the likelihood that the bond would not be redeemed at that time, you would be out of pocket on the investment. anyone disagree?

  22. 27/06/2012, Jack wrote

    I think I agree with Mike, although im no expert on this subject. But it seems to me that the bond trades at its current price, and therefore pays out effectively at a rate of around 8%, to reflect the risk involved with this kind of low grade bond. Now, come the end 2015, if interest rates are still low, then the headline rate from this bond will fall from 5.55% to maybe half of that (LIBOR + 2%). Therefore for the bond to still pay out at an effective rate of around 8%, its price might half, resulting in a large capital loss on the investment, which would more than offset the interest received over the 3.5 years?

  23. 27/06/2012, dlp6666 wrote

    But maybe the likelihood is that Co-op will actually redeem – something to do with Tier I obligations as per this recent article in Money Observer:

    http://www.iii.co.uk/articles/32011/needs-headline

    What do you make of it?

  24. 27/06/2012, mike wrote

    Assuming Bengt is still reviewing the comments, i would like to ask his brief view (or anyone else’s) on the Lloyds ECNs, paying around 10% at current prices, with actual redemption dates varying between 2019 and 2024. Some of them also offer about a 20% capital gain on top. I bought a load at rock bottom prices but they still offer great value. They are compulsorily exchanged for shares should Tier 1 capital go below 5% – which is a long way off but not impossible.

  25. 27/06/2012, bengt wrote

    Mike, Jack, Gary

    I can’t see the bond dropping off that much in the case of non-redemption. Remember, even if 3-month libor remains around the 1% mark, then the nominal rate on the bond is 3%…

    But by buying in at 68.5p gets you a rate of 4.4% (3/68.5)

    If rates go up, then you get even more.

    Worst-case scenario, if there’s no redemption, maybe the yield goes to 6% for this Co-Op bond… that would see the bond price drop to 50p (and that would be if interest rates don’t go up at all).

    But even if that happens, then holders will have had around 18p in coupons in the meantime (breakeven on today’s prices).

    So from what I can see, worst case scenario, you break-even.
    Best-case scenario, you earn near-on 17% p.a. for the next 3 and a half years.

    And somewhere in-between, you end up with a libor tracker, which could provide a solid interest rate tracker where you’re getting in at a substantial discount to par (effectively giving you a leveraged tracker).

    Bengt

  26. 28/06/2012, Roger wrote

    I would urge caution. This case looked just as good 2 years ago and I piled in, but am now sitting on a 15% capital loss.
    This is a bet on future interest rates, and indirectly inflation. Rates were expected to be back to ‘normal’ by now when I bought, where will they be in 2015, answers on a postcard to……

  27. 28/06/2012, mike wrote

    what do you say to Lloyds ECNs Bengt (comment 24 above).
    many thanks

  28. 28/06/2012, Stephen wrote

    Inflation risk is not fully spelled out in comments to date. IF LIBOR does go up, that will most likely be for one reason only- rising inflation (i.e. MORE than the recently experienced 4% levels…) Now if inflation is running at say 8% and rising, what yield are investors in PERPETUAL bonds going to demand, in an environment where real short-term rates remain severely negative? I’d say somewhere between 8-15%. These bonds could actually lose capital value in nominal terms over the next ten years.

  29. 28/06/2012, dlp6666 wrote

    Your ‘worst-case’ scenario might be worse, Bengt.

    Firstly, as per Roger’s caution, what happens if we end up in a Japan-like situation where interest rates and LIBOR don’t rise?
    Secondly, why do you think that the [floating-rate] bond should ultimately price in a yield of 6%? The other Co-op Bond (13% Perpetual) is currently priced to give a running yield of around 8.5%. If this bond follows, then it would have to be priced at around 35p (not 50p).

    Looks like a £350 per 1,000-unit gamble on £300 gain IF Co-Op redeem-not now so sure how likely after reading this FT article: http://www.ft.com/cms/s/0/60114864-afd6-11e1-b737-00144feabdc0.html#axzz1yo5kdCfi. Refinancing at LIBOR + 2.05% is more expensive than the +1.05% that Principality settled for last year but Co-op may well still consider that to be cheaper than other options.

    As Roger says, it does seem to be a play on what interest rates/inflation will look like at the end of 2015.

  30. 28/06/2012, dlp6666 wrote

    Stephen – I’d have thought that if inflation becomes rampant, then LIBOR rises with it – and so does the coupon on this bond, which is reset quarterly.
    So if the coupon is going up in line with rising LIBOR/inflation, then presumably it becomes an increasingly attractive bond and the capital value rises accordingly.
    Though I’m not sure at what level the running yield would ‘stabilise’ (perhaps more than the 6% Bengt was suggesting).

  31. 01/07/2012, donald wrote

    i will not buy the bond you will not get the 16% return why would they buy it back 200,000,000 non repayable money at 2% abouve libor average rate for libor 2.1% last 10 years.. so youll get 4.1% say no capital returnable.. ever..

    the existing holders of this bond have already recieved a raw deal and its a sub.

    just buy a good dividend paying share with very little debt on a sub 10 pe… youll likely double your money every 10 years and still get your money back when you want it.. stick it in an isa and its tax free.

    simple no special hope measures required.. if extra cautious build your investment up monthly over years to average the market.

  32. 02/07/2012, John wrote

    I have held these bonds for many years and originally bought them as Britannia Building Society PIBs. They are currently held within a T D Waterhouse ISA (I transferred them from a Selftrade ISA). I think the point that some people are missing is that, regardless of their absolute qualities as an investment, they do add DIVERSITY to a portfolio, thereby reducing volatility in performance, and I also judge that they are quite a safe investment. In the currently financially troubled times, I value these two qualities so I will continue to hold them.

  33. 02/07/2012, 4caster wrote

    An advantage for ISA investors is that these bonds pay interest, not dividends. Interest is paid gross into a stocks and shares ISA with no deduction for income tax nor advance corporation tax. I bought mine through an Alliance Trust Savings ISA. It is not is their list for online trading, so I had to buy it by telephone, in multiples of £1,000 nominal. They charged me £12.50 commission, but on 1st August 2012 their telephone dealing charge rises to £40.

  34. 15/04/2013, Pat wrote

    Hi,

    I did not buy into your original advice on these bonds as I was a bit late to the party – price had risen too much for the risk involved. I note the recent price drop to 68.
    Do you now what is behind the price drop and secondly do you still think these are still a good buy at these levels?
    Thanks

  35. 15/04/2013, shebiii wrote

    Same comment as Pat – would have been interested in buying but the price shot up quite a lot. Is it that the Co-op cannot now be viewed as an old- fashioned bank anymore, they made a lot of losses at the end of last year and are buying a shedload of Lloyds banks. Can they change this into a Coco?

  36. 10/05/2013, Nick wrote

    I have owned these Bonds since December and not yet received any Interest. Do you know which month it is paid and is it bi – annual?

    Hoping you can help

    Nick

  37. 11/05/2013, Dan Wilmott wrote

    Would appreciate your thoughts on this bond for investors
    after co-ops downgrade by Moody’s yesterday and large price drop! thanks.

  38. 12/05/2013, Andy G wrote

    Bengt please let us know what you think now, I’m very tempted at 50p levels. Is the rest of the co-op group able to stand behind the bank will they go after share and bond holders if losses escalate ?
    Thanks

  39. 13/05/2013, Leigh M wrote

    Nick, the interest is paid every six months, the next is due 14/06/13.

  40. 13/05/2013, John J wrote

    I purchased a significant amount of these bonds at 73p.Following the fall in price,please could you publish your current view. Many thanks

  41. 14/05/2013, DGL wrote

    I’ve just bought the OTHER Coop perpetual bond….got a coupon of 13% I paid c. 97p (with charges) per £ 1 holding giving a yield of 13.4 %
    into an ISA – sweet !
    Not sure I understand the risks !

  42. 18/05/2013, Paul Claireaux wrote

    To DGL. I sincerely hope you do understand the risks but you wouldn’t be the first who didn’t. So in case you’re not joking here are the risks: a) 100% of that juicy income and b) 100% of your capital.

    How does it look now ?

  43. 18/05/2013, Paul Claireaux wrote

    The comments here evidence the great confusion about risk with corporate bonds. The chase for yield is clearly prompting people to grab at this stuff without any understanding of those risks.

    What is more the risks are increased manifold with bank corporate bonds as these institutions are amongst the most leveraged (use debt rather than capital) of any potential borrower.

    The risk to your capital is very real indeed. Be aware.

  44. 20/05/2013, gamesinvestor wrote

    3 1/2 years??
    December 2015 is 2 1/2 years

  45. 20/05/2013, gamesinvestor wrote

    Based on the 2 1/2 years the yield is over 20%.

    But there are far more important factors to consider here than the yield on a loan that will be written off in the event of a corporate liquidation.
    There is no guarantee that that the banking division will have any support or can rely on a bail out from any other part of the COOP businesses.

    There is a reason why the bank pulled out of buying the branch network from Lloyds and this has been scrutinised by Moody’s. Moody’s have identified that the bank has no cover it’s technically close to insolvency if you apply the new guidelines from Basle.

    In a nutshell it’s important to think a little deeper than the headline yields. In any case, if everyone bought into this, the payments could wipe out Coop banks finances.

    Probably better to accept a modest yield on a solvent low debt company.

  46. 23/05/2013, IanF wrote

    @ gamesinvestor
    Quote ‘ In any case, if everyone bought into this, the payments could wipe out Coop banks finances ‘

    You are confused, this is an existing issue not a new one. Thus they are already paying the coupon on it. However their recent down grading by Moodys makes it seem less likely that they will call it in Dec 2015. So any investor should plan on the coupon being re-set to 2.05% + 3month Libor.

  47. 02/07/2013, Edj wrote

    The logic in your article appeared compelling. Now that the regulator seems to have changed the goal posts have you updated your view on the value of these bonds.

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