How to get more out of your bank than the savings rate

Why settle for an Isa when, for a tad more risk and legwork, you could get higher yields from your bank? Riccardo Marzi investigates.

What kind of rate are you getting on your savings account right now? 1%? Maybe 2%? What if I told you that while the banks pay this paltry return on your deposit, they are paying more to investors in other debt instruments sometimes more than 10% a year?

What if I told you that these debt instruments have fallen in price after the banking crisis and are still trading at a substantial discount to face value, even though the worst of the crisis seems to be over? And what if I said that many of these securities can be bought by retail investors willing to put in some legwork?

These securities exist. They're known as tier 1 securities, and here I'll explain why they're well worth a look for more adventurous investors.

How a bank works

Once we understand banks, we can grasp the nature of these securities better. A bank's business model is pretty straightforward. It borrows money at one rate of interest (from depositors in savings accounts, or from other banks, for example) and then lends that money to someone else at a higher interest rate. It also has capital raised from share- and bondholders. So a simplified version of a bank's balance sheet looks like this:

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Let's focus on the liabilities. I've put these in order of seniority. If a bank goes bust, depositors get paid first, and equity shareholders are the most vulnerable. Tier 1 capital includes the value of the ordinary shares, plus the tier 1 securities issued by a bank. Tier 1 securities include bonds and preferred shares, which pay a set amount of interest each year.

We'll go into the key features shortly, but the thing to remember is that these are senior to the equity tranche so equity holders have to be wiped out before tier 1 holders lose anything. Tier 2 capital splits into two types: upper tier 2, which takes the form of perpetual securities similar to those above, but with added seniority; and lower tier 2, which are just normal bonds with a set maturity date. Together these form the bank's capital, the buffer that absorbs losses.

The key features of tier 1 securities

What we're most interested in here is the tier 1 securities known as 'hybrids', which combine features of debt and equity. They have a nominal (face) value expressed in pounds or euros, like a bond generally £1,000; holders do not get to vote at the AGM; and they have a fixed rate of interest, also like a bond. Their other main features are as follows:

They are senior to the other equity the ordinary shareholders who have to be wiped out before these securities lose out.

They are perpetual (or irredeemable), but every issue is callable (redeemable) by the bank at a specified date. After the call date, the interest rate paid by these securities steps up. The specifics depend on the bond in question, but it's usually something along the lines of Libor plus 3%, payable each quarter. (Libor is one of the main interest rates at which banks lend to one another).

The interest payment can be suspended without triggering a default, but if that is the case, the issuer is restricted in certain other payments it can make.

Although they're perpetual, it's standard practice that the bank redeems these securities at the first call date and pays face value for them, but this isn't guaranteed.

However, if they are not redeemed at the date of first call, these securities are designed to trade close to par value anyway. This is done by changing the interest rate they pay to a variable one (usually a certain rate over and above Libor) and giving the bank the facility to redeem them at every quarter.

As they are quite complex, I will give you an example. Take the following: ISIN: XS0107228024; Lloyds Group 7/2/2015; coupon 7.83%, paid in pounds.

This tier 1 security is issued by Lloyds Group, which is 70% owned by the British government. It pays a coupon of 7.83% a year until February 2015, when it can be repaid at par value. The bank is not obliged to do so, but if it chooses not to repay the capital, then holders will receive an annual interest payment equal to 3.5% above the five-year gilt yield.

Given that the Bank of England base interest rate is 0.5% and that the amount of money paid by your bank on your individual savings account (Isa) or deposit account is around 3% at best, how much would you expect to pay for such a security, given that it's paying an 8% yield? Above or below par (bond jargon for more or less than face value)?

If your answer was above par, you'd be wrong. The Lloyds security is quoted at around 74 to the par. That means you pay £7,400 for each £10,000 of these securities, giving a yield to maturity (see below) of roughly 15%. So if you were to invest £10,000 now and wait until 2015, you should have just under £20,000 £10,000 buys you around £13,500 of stock, paying roughly £1,050 a year for six years not a bad return at all.

Why buy now?

Now these securities are by no means risk-free. They're not for widows and orphans and you could lose money on them.In a worst-case scenario, your entire investment. But I believe that with yields that can exceed 10%, the risk/ reward profile is highly favourable.

The main risk is that the bank issuing these securities loses so much money that it stops paying dividends, or even worse, is nationalised. In the first instance, if it stops paying dividends for one year, say, the capital would remain intact a failure to pay interest doesn't count as a default. But if the issuing bank is nationalised, the risk grows significantly. Precedents are few and far between, and no one really knows exactly how these securities would be treated in the event of a nationalisation which is one reason why their prices have fallen. In the case of Anglo Irish Bank, for example, it was nationalised as insolvent and the holders of tier 1 securities were wiped out. Meanwhile, Northern Rock has just announced it will stop making interest payments on certain types of its subordinated debt.

But for now the risk of a bank failure or a forced nationalisation seems to have receded. Talk of a storming recovery may be premature, but the financial system certainly seems to have stepped back from the brink. Provided we don't enter a second recessionary phase on the same scale as the one we've seen in the past year, nationalisation or bank failure should be off the table. All the major UK banks have issued strong sets of results in the past few weeks. While there was some disparity between the strongest (HSBC and Barclays) and the weakest (Lloyds and RBS), each posted a strong operating profit that was almost enough to cover impairments and write-downs. Importantly, each also repurchased its own tier 1 securities at a discount. So going forward the price of these bonds could be supported by the banks buying back their own issues.

On top of that the asset insurance scheme put in place by the British government guarantees more than a quarter of the loans made by the two weakest banks, Lloyds and RBS. Most of the write-downs these two took in the first half were related to assets placed under this scheme, so that shouldn't be repeated in future.

As the banking sector is strategically important, it's almost certain that the banks will be allowed to earn their way out of the current crisis. Bad assets will not be written down at once, threatening the solvency of the banks, but gradually written off over years as the banks use future earnings to offset past losses. Meanwhile, to help guarantee profitability for the banking sector, the Bank of England has widened the interest rate spread (the spread between interest paid on deposits and the one paid on loans), by lowering interest rates. As you've probably noticed, you get around 1% on your deposits but pay around 4% on your mortgage. Up until 2007 this spread was close to 0, forcing the banks to leverage up to maintain profitability, but not anymore and that makes day-to-day banking a very profitable business.

Finally, there are a couple of other reasons to like tier 1 securities. Shareholders in banks will not be receiving dividends for a while to come, as the overall profitability of the banking sector will still be poor for a few years yet. However, tier 1 securities pay a fixed coupon. Also, if the bank has to issue new shares to raise more capital, shareholders will be diluted whereas the nominal face value of a tier 1 security stays the same. So which tier 1 securities do we suggest and how can you buy them? See below for details.

What to buy and how

Prices for many bonds can be obtained by registering free at www.indexco.com, but be wary as they might not be bang up to date. You can then search by issuer (RBS, Lloyds, Barclays) or by ISIN number to get an idea of the various types that have been issued. The securities can be purchased and sold by most major brokers, although as liquidity is much tighter than for stocks, you may not always be able to trade. If your broker has difficulty it may be best to try a broker with more experience in this area, such as Killik (020-7337 0777).

But take extra caution when dealing. Ask your broker for a price quote from Bloomberg or Reuters and aim to deal around about that price. And always buy or sell using 'limit orders' (orders where you place a price limit, above which you are not prepared to pay). As these are quite particular instruments, when you phone your broker always give them the ISIN number or the issuer coupon and maturity date. Once you have identified them, ask your broker to contact the market maker that displays the best price (or the two market makers displaying the two best prices). Be prepared there's a good chance that you might have to trade at prices outside the spread for quantities of £10,000 or less.

Apart from that, the rest is much like trading a stock. Liquidity in these bonds varies, but you should be able to deal in sizes of up to £250,000. The minimum size is £1,000 in nominal value for most of them. But some have minimum sizes of around £50,000. However, remember that if you buy £10,000 nominal of a bond trading at 50, you only pay £5,000, so the 'minimums' are not quite as restrictive as they might first seem.

It's important to understand that these bonds are most suited to investors who plan to hold them until they are redeemed. That's because the main trading risk for these bonds is the spread between bid and offer. In other words, if you need to sell in a hurry, you will only be able to sell at the bid price, and especially for bonds trading well below par this can mean significant losses. For example, if the spread is 60-66, if you buy on the offer at 66 and you want to sell because of unforeseen circumstances, you will only be able to sell at 60, meaning a 9% loss right away. For smaller investments which will probably face a bigger spread the risk can be even higher.

Volatility in these securities is also much higher than in a normal bond. They tend to be correlated to the price of the shares of the issuing bank, so expect the price of these securities to drop if corresponding equity prices fall and vice versa. And if you decide to invest in securities priced in euros or dollars you also have currency risk if the pound strengthens you might lose some of the amount invested (the opposite of course is also true).

What to buy

This is not an exhaustive list of the tier 1 bonds in issue by any means, and you may wish to investigate other tier 1 issues, particularly if you have a longer time horizon to invest over www.indexco.com is a good starting point. However, I have listed six securities that I believe look attractive at these levels (see table), and which provide a range of options with different minimum investments and different durations.

More risk-averse investors may want to opt for issues from Barclays over those from the part-government owned banks, such as RBS and Lloyds. However, do bear in mind that, unlike Northern Rock, which was fully nationalised, RBS and Lloyds remain listed and to all intents and purposes are operating as public companies. If they were to stop paying coupons on their tier 1 securities it would hurt their credibility and make it difficult for them to raise capital on the markets in future.

Bond jargon buster

Clean price

This is the price of the bond without accrued interest. Prices quoted by brokers are always clean.

Dirty price

This is the price of the bond with accrued interest. The dirty price is what you actually pay for the bond. For example, let's say that on the 30 June 2009, I buy a bond paying interest on the 31 December 2009 at par (100) with a 10% coupon. I will pay 100 (clean price) + 5 (the accrued interest or six months of 10% annual interest). So my dirty price (or the amount I will pay) will be 105.

Yield to maturity

This is the annual interest you will earn if you buy the bond then hold it to maturity (or in this case, the call date). It is the sum of the coupon and the difference between the price paid and the nominal value, divided by the number of years to maturity of the bond.

For example, if I buy a five-year bond with a 6% coupon for 95, then my yield to maturity will be 7%. That's the 6% coupon plus (100-95)/5 or 1%. I paid 95 for a bond that pays me 100 in five years' time, so each year I gain an extra 1% in yield (in reality it's a bit more as the coupon of 6% should be divided by the price, or 6%/95 = 6.31%, but I've kept things simple here).

When bonds are trading at a fraction of their par value, the yield to maturity gets more extreme. Say I buy a bond for 33 to the par (33% of face value) maturing in ten years with a coupon of 5%. My yield to maturity in this case would be 5%/0.33 + (100-33)/10. That's 15% + 6.7% which equals 21.7%.

This article was originally published in MoneyWeek magazine issue number 449 and was available exclusively to magazine subscribers. To ensure you don't miss a thing, and get instant access to all our premium content, subscribe to MoneyWeek magazine now and get your first three issues free.

Riccardo Marzi is the author of the Events Trader newsletter. Find out more about Events Trader here.