My Best Yield Idea: RBS Preferreds

| About: The Royal (RBS)

In an era of desperate seekers after yield, people should think about Royal Bank of Scotland (NYSE:RBS) preferred shares. These were issued at various times by the troubled British bank to raise money from US retail investors. These American Depositary Securities issues actually have no British equivalent stock. They came out at $25/share, meaning most Americans could buy a round lot for $2,500. The preferreds offer generous dividends, goosed up by the British advance corporate tax (ACT) system. ACT allows the issuer to add back to the payout dividend going to the US investors the amount of which taxes on the payout which had been paid to the Inland Revenue Service (the UK IRS).

In order to count toward a bank's solvency under Basel rules on capital adequacy, the preferreds have to be "non-cumulative," meaning that a dividend missed will not be made up for.

British banks developed the market for these preferreds starting in 1990 with Barclays Bank. But RBS, which kept buying other banks with reckless abandon until it crashed, was the biggest issuer of the preferreds with a whole alphabet of them, plus another issue on behalf of National Westminster, a bank it acquired. The recipient of the payout has to pay taxes, so these goodies do not work in a tax-deferred account unless you are willing to forgo the withholding tax applied, because the payout is so good. Or you can invest in British bank preferreds for capital gains. Under UK law, the preferred shareholders are senior to common shareholders and will always get their dividends before the commoners.

There are three classes of RBS preferreds out, all of which trade on the NYSE. The first group were issued before the global financial crisis of 2008 which resulted in the 82% nationalization of Royal Bank of Scotland, and have paid out regularly with no interruption. Their letters are F and H from Royal Bank of Scotland, plus the NatWest C (the only NatWest stock now traded). They are unlikely to be called because where would RBS get the money?

The second and third group of shares were required in early 2010 or 2011 to temporarily suspend their dividends (which would not be made up for later) under a European Union ruling. This was to prevent the fact of government ownership from giving RBS an edge over competing banks. The application of EU competition rules against state-controlled companies (as RBS now is) are unlikely to be repeated.

For reasons involving the US prospectus terms, one group of dividend-suspended Royal Bank of Scotland preferreds resumed payout last year. A second group of dividend-suspended RBS preferreds will resume paying out only this year. The second group of preferreds were issued for the fatal takeover of ABN-AmRo Bank, the last hurrah of the former RBS management, but they now trade as RBS not ABN but do not bear the full name (perhaps to save money).

The alphabet letters paying out dividends, having resumed payouts last year bear the letters L, M, N, P, Q, R, S, T, and U.

And the ABN-AmRo ones which will start paying out again this year (having only been suspended in 2011) are the E, G, and I shares.

Retiring Bank of England governor Mervyn King proposed in testimony before Parliament on March 4 that Royal Bank of Scotland be split into a "good bank" and a "bad bank" to cut down on the time RBS spends owned 82% by the UK government. This has boosted the share prices of our RBS preferreds. King, who is due to be replaced by a Canadian, told a parliamentary committee that the government ownership "has dragged on unnecessarily long" and was mishandled. The current British coalition government attempt to show a profit when it sells RBS back to the private sector he called "a nonsense."

The UK coalition government wants to sell the parent Royal Bank of Scotland (whose common shares also trade in the USA but pay now (Scottish for nothing) in dividends; they were subject to a 1:10 reverse split by changing the ADR ratio last May. RBS common was downrated this month by Societe Generale and because its shares fluctuate based on the UK regulatory climate and the sins of the past (Libor-fixing, misselling mortgage insurance, and other horrors), the common shares are a pure speculation and the best one can hope for is that some benighted buyer will put Downing Street out of its misery by buying up assets from RBS. US investors are hovering around some parts of the bank's retail network, after the Co-Op Bank of Britain backed off a purchase.

RBS has recently sold its hotels in Dubai, which nobody had any idea it owned. These were taken over when the Gulf country's property market collapsed, since good old RBS had helped finance their construction. It is also attempting to sell its shuttered investment banking arm, and part of its branch network. It also owns the posh private bank, Coutts & Co., where Queen Elizabeth II has her check account. Presumably someone might be tempted to buy that one.

Meanwhile the UK government is using RBS to force money into financing small business. You don't want the common but work to salvage the common doesn't remove the obligation to pay our preferred dividends.

Because the prices of these preferreds varies from day to day, I am not posting the yields here. But they are extremely generous in a period of low inflation and low interest rates. I think the risk is minimal. If the bank is sold in its entirety, which is unlikely, the preferreds would continue to earn dividends.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I recommend and own RBS preferred E, G, and I; Nat West C; Royal Bank of Scotland F, P, Q, R, and T