8th September 2009
A new opportunity in bank debt
Dear Hannah Jordan,
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Welcome back. It's been a busy week for the trades and stocks we've been watching. There's been some interesting news on hybrid securities which has thrown up a new investing opportunity in bank tier 1 debt; and the National Express situation continues to develop. But first, let's take a look at the latest news on the Oracle / Sun deal and how it affects our risk arbitrage strategy.
The EU investigates the Oracle / Sun deal as expected
Let s start with the proposed acquisition of Sun Microsystem by Oracle. This was one of our risk arbitrage plays, tipped back at the end of July (issue 12). As you may remember, last week I mentioned that we were shortly expecting the European Commission's decision on this merger.
Unfortunately, the Commission has decided to extend its investigation into the merger, on concerns that the deal could restrict competition in the database markets. Oracle is the leading player in database software. By acquiring Sun, Oracle would acquire MySQL as well, which is the leading open-source database, and is used by a large number of websites.
The Commission now has until 19 January 2010 to reach a decision. Oracle may be forced to make some concession, such as selling MySQL perhaps.
So what now? Despite the delay, legal experts quoted by Reuters reckon that the deal should ultimately be cleared by the European authorities. To put things in prospective, the database market is worth $19bn per year of which Oracle accounts for $9.2bn, while MySQL is only $300m. So even if a sale was required, I do not think the merger would be derailed.
It's also worth noting that the US competition authorities cleared the deal two weeks ago after asking for more time to examine the takeover back in July. In my view, the US authorities posed a greater risk than their European counterparties.
If you remember, when we first discussed this idea, I was factoring in a possible delay of a couple of months in the return calculation. This is exactly what's happened. After the news that the EU was opening an in-depth investigation, Sun Micro (US: JAVA) stock fell 1.8% and is now trading around $9.15, a 4% discount to the takeover offer, and around 1% lower than when we tipped the stock.
So if you aren't already in, it's still worth getting involved in the deal, as now the annualized return has grown to 16% (4% in three months). For more on how to trade this merger, see issue 12 (available in the Events Trader archive, password: Victory). But if you already own the stock, do not panic and simply hold on to the position.
A revised offer for National Express but don't buy yet
This stock is definitely getting on my nerves!
CVC and the Cosmen family came back with a revised final offer of 500p per share last Thursday, and this time it's not conditional on National Express (LSE: NEX) retaining its remaining rail franchises. However, it still needs the approval of the NEX board, who have said they are considering the offer and will make a statement when they deem it necessary.
The stock rose to 465.9p, as this time, the market expect the offer to be accepted. I continue to believe that it's better to wait and sit at the sidelines, as the risk of a capital raising has not gone away. Once the offer has been approved and the risk of a rights issue has gone away, we might play the deal with the risk arb strategy. At the moment the spread (between the offer price and the current price) is 6.8% but might close a bit further.
Do bear in mind that the potential downside on NEX shares is now in my opinion around 50% if the deal is rejected. So please be careful if you decide to get involved before any further news comes out.
RBS won't call four hybrid bonds what does it mean for tier 1?
In a statement issued on Friday, RBS said that four hybrid bonds which had their first call date before the year end will not be called. The securities affected are two upper tier 2 and two lower tier 2 bonds that are similar to our tier 1 securites, but senior in claims.
The decision was instigated by the Financial Services Authority (FSA) and the European Commission which ruled on 19 August that banks which had received state aid should not use taxpayers' money to repay equity and subordinated debts that were designed to absorb losses.
This might seem like a disaster, but in fact, it's not the end of the world. These bonds will not be called or repaid at the first call date, but they will continue to be liabilities of RBS unless the bank defaults or is nationalized. Let me explain in more detail.
This isn't a disaster it could spell opportunity
These bonds are perpetual securities that can be called (repaid) by the issuer only at a specified date. When this date is reached, two things can happen:
A) Either the issuer repays, which was up until the credit crunch what normally happened;
B) Or the hybrid bond converts into a different type of bond, generally with a higher yield tied to Libor (a key interbank interest rate) or to the yield on UK gilts. The issuer then can decide to call them whenever he likes (usually once every three months).
These features mean that if these bonds are not called, they should trade near or at parity. After all, they pay a premium over Libor (they offer an above average interest rate) and opportunities for the issuer to redeem them come every three months (so your money isn't locked up for long). What's happened here is that RBS has decided to use option B.
One very important fact needs to be pointed out here. I talked to investor relations on Friday, and he confirmed that this decision (for the moment at least) does not affect the payment of the coupon on these securities. Why not? Because if they don't pay the coupon on these ones, they can't buy back other tier 1 bonds, which as you might know, is a trade which has made quite a lot of profit for the bank in the past six months.
So although the securities will not be called, the coupon payment looks "reasonably" safe to me. This is also not the first time that a bank has decided to use option B. Deutsche Bank decided not to call a tier 1 security back in January, because it was designed to convert to Libor + 97 basis points (in other words, it was cheaper to roll over the debt than to redeem it).
So what does this mean for our tier 1 bonds?
The main point to note here is that for as long as RBS is listed and operating, these bonds are not in default and will carry on paying the coupon at the revised rate stated in the prospectus. So believe it or not, there might even be a buying opportunity if you are prepared to wait a few months or years while the dust settles.
The other big risk is that the bank might decide not to pay interest. But in the prospectus for some of these bonds, one of the conditions set for non-payment of the coupon is that the bank faces restrictions on how it can use its capital. In other words, it can't pay dividends or pay back other securities (however, always check the prospectus, as this conditions might vary from bond to bond).
This means two things: firstly the government would not be able to get its money back from the bank if the coupon is not paid (and at the end of the day, the government would like to make some money out of this deal). Secondly, the management would have already suspended the coupon payment if it thought that the benefits of non-payment would outweigh the negatives.
For listed banks, the market is their main source of capital. This event does not help the sector in this quest and it means that more taxpayer-led intervention might be coming. These types of hybrid securities also proved very bad at absorbing losses, and the regulators are studying ways to replace them, so they will be on the way out soon, which is all the more reason for banks to redeem them in the medium term.
This news has also implication for Lloyds. Expect their tier 1 and tier 2 bonds not to be called until they get rid of the government capital. This might take three to five years (maybe a bit more for RBS). Barclays and HSBC should not have problems.
Again the coupon payment should not be a issue, unless some other major crisis comes along. The coupon and principal payment could be put in jeopardy if the banks were to be nationalized, but given that the Tories are the likeliest next government I do not see this happening. I think it is much more likely that a bank is nationalized in countries like Germany, France or Italy, with their tradition of state intervention. Over here I would expect two to three years of balance sheet repair and then back into private hands after the government has been repaid.
All in all, investing in this type of security comes down to your view of the banking sector. If you think it will end up bankrupt, then this investment is probably not for you. On the other hand, if you think these British banks have done enough to save their skins and they will continue to exist in the future then it is definitely worth a look as the yields you can get are far higher than even emerging markets securities.
How to value these four bonds
The four securities in question are two euro issues and two issues in Australian dollars (AUD). I would leave out the issues in AUD as the risk section would be much longer than the strategy bit also the minimum size investment for the Australian dollar tranche is 500,000 AUD.
So let's focus on the two euro-denominated issues.
XS0102480869 is the most liquid, with €400m in issue. XS0102480786 is the least liquid, with €100m outstanding. The minimum investment size is €1,000 for each.
After the call date, these two securities will pay Euribor (see below for a definition) + 215 basis points (2.15%). This is calculated on an annual basis, but paid out quarterly. RBS can decide to redeem all of them (not just part) at par every three months from now on. The probability of redemption at par value to me seems remote for now. But once the bank is back on track in say three to five years, redemption is very likely. That's because the bank will want to replace these securities with a less expensive form of capital.
Valuing these bonds now is simpler. Basically you hold bonds that pay a variable interest rate plus an extra 2.15%. So unless there are issues about the creditworthiness of the issuer, the price should be close to 100 or par eventually. In this case, the larger issue trades for 69-70.5. If you can buy it at 70.5, you will have a variable rate bond paying 142% of Euribor (100/70.5 * 100) + 3% (2.15 * 142%) of your invested capital.
(If the maths is confusing you, remember - if you invest £7,000 at 70, you are buying £10,000 face value. You'll get Euribor plus 215bp on the £10,000 face value, not on the £7,000 investment.)
On top of that, you are getting an asset that will eventually be repaid at 100, for 70 right now. The only catch is that you can't say when it will be repaid. It could be 3, 5, 10 or 20 years from now. But eventually they should be repaid.
Usually variable rate bonds should trade very very close to par value. So once RBS's credibility is restored I'd expect this bond to do the same, so that even if it's not redeemed, you could sell it on, hopefully close to par value. Also this bond can be called and repaid every three months now, so that's an even bigger reason for this bond to trade close to parity.
Please note too and this is very very important that if inflation rises, you will be protected, because the Euribor will rise as well. Let me say that again: if inflation rises, you will receive a higher coupon, as the Euribor rate will rise with it!
So to carry on with our example: let's assume that this bond will be redeemed in five years at par, and that the Euribor will average 3% for the next five years. On your £10,000 worth of bonds, you'll receive £515 a year in interest, plus £3,000 in capital gain. So after five years, your original £7,000 has grown to £12,575 or a profit of £5,575. That equates to £1,115 (£575 in interest and £600 in appreciation) a year, or 15.9% a year.
Do be aware that this can change to the downside if the bank redeems them earlier than five years; or if it decides not to pay the coupon (which is possible); or if the bank goes bust (which I believe is unlikely, but is of course, still possible); or if interest rates rise more quickly.
There is one final thing: these securities are Upper tier 2. So before you take any losses, all the equity capital and the tier 1 capital will have to be wiped out. Believe it or not, your claim as a tier 2 holder is senior to the government. So unless the bank goes bust you should be OK. This is why I have decided to put the first security (XS0102480869) in our portfolio. I suggest you buy it as long as it fits your investment needs but do be aware of the risks I've pointed out above, and understand that if you want to get out before the bond is redeemed, you may well have difficulty doing so if conditions haven't improved for RBS.
As usual you can contact me at email@example.com, I will be more than pleased to answer you.
Euribor a definition: Euribor is the Euro interbank offer rate, or the rate at which banks lend to each other. Do not confuse Libor or Euribor with the rates set by the European Central Bank or the Bank of England. Libor and Euribor are determined not by a central bank, but by supply and demand.
Your capital is at risk when you invest in shares, never risk more than you can afford to lose. The share recommended is denominated in a currency other than sterling. The return from such shares may increase or decrease as a result of currency fluctuations. Please seek independent personal advice if necessary.
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