Royal Bank of Scotland - Time to Buy Preferreds?

 |  About: The Royal Bank of Scotland Group plc (RBS)
by: Rubicon Associates

Reuters reported:

Royal Bank of Scotland is considering a liability management exercise that could see it buy back or convert part of a 14 billion pound ($21.5 billion) pile of preference shares and innovative securities to boost its core capital. Bruce Van Saun, the bank's chief financial officer, told analysts:

Clearly we have a window here to study a liability management exercise and we certainly are considering our alternatives there.

It is not an easy equation with all the changing regulation around capital quantity and capital quality." He added the bank expected to reach a conclusion by around mid-March. The bank has a string of options for further so-called "liability management."

This has been speculated for a while (trader whispers and news hints), but seems to be gaining traction with the company. So do you buy preferreds and wait/hope for a tender at higher levels? Not a bad idea in my opinion. For example: the RBS L traded at $15.45 yields 9.3% and does not seem to be a target of the company or government as a possible candidate for a dividend stop. Downside: Preferreds are not tendered and drop a bit (hard to quantify), investor still pockets a 9%+ yield. Upside: RBS tenders for the preferreds above market price and investors get the tender premium (would expect at least 10%, surpassing the yield).

There is also the "must pay" and "may pay" delineation among the preferreds which must be taken into account. From Moody's (12/22/09):

However, one factor which Moody's considers to remain uncertain and which could affect the eventual outcome as to which securities will pay and which will not pay in 2010-2012 is the availability of distributable profits. Certain non-cumulative preference shares (which also act as a dividend pusher for certain UT2 and LT2 securities) are only able to pay subject to the availability of distributable profits. At June 2009 the holding company of RBSG had distributable profits of GBP5.5bn, but losses in H209 could erode these reserves.

and it continues:

The securities that are expected to skip coupon payments ("May Pay" securities) based on language providing fully optional deferral will continue to be rated on an expected loss basis, which factors in the anticipated period of coupon non-payments and the loss severity. The securities that could potentially not skip coupons if RBSG has sufficient distributable profits ("potential Must Pay" securities) would be notched down from the Baseline Credit Assessment ("BCA"), in line with Moody's revised methodology for hybrids. If distributable profits turned out to be not sufficient, then Must Pay securities would be rated at the same level as May Pay securities.

While you should read the various prospectuses, here is a list of the two as I know it:

May pays:

Cumulative and Must pays:

Bottom line: I believe that these securities (the "must pay") provide decent yield and the ability for upside. Keep in mind I own two series of the "must pays", but do not believe I am writing biased or trying to unload these.

Disclosure: Author long RBS L and NW C.