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.

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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 halfyears 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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