Royal Bank Of Scotland: Preferreds Are Attractive

| About: The Royal (RBS)

Royal Bank of Scotland (NYSE:RBS) preference (preferred) shares have been a focus of mine over time due to the outsized gains I believe(d) they hold.

Back on March 6, 2012, I wrote an article regarding Royal Bank of Scotland's preference shares in which I arrived at the following conclusion:

Conclusion: The market is expecting RBS' currently suspended preferreds to begin paying the dividend again. As a result, it is possible to buy shares and end up owning high yield preferred shares with a built in gain.

I do have to stress that no announcement has been made at this time regarding the resumption of dividends on the suspended preference shares. The conclusion has been arrived at utilizing a "mosaic theory" approach looking at current pays, distributable profits, market pricing and peer actions.

Then on April 4, 2012 I penned:

Again, I must caution potential investors (and current investors) that RBS has not formally announced the reinstatement of the dividends on the preference shares. At this juncture it continues to seem increasingly likely that they will.

Well folks, the company has now announced that they will be turning on the preferred dividends of their "may pay" securities. The gain to investors since my first recommendation:

These are two month gains. Over the same time period, the S&P 500 has returned 5.19%. Not bad.

So, is this a "hey look, I was right" article? No. This is a what is the next leg of the trade article. Lets begin.

We have hit our 9% target with the "may pays" (let us now refer to them as "will pays") and I believe the next stop is around 8%. What is this based on? Take a look:

(Click to enlarge)

So it looks like the currently paying preference shares are around 8% (except the NatWest Cs, which remain cheap at 8.38%). If we were to adjust the price of the "will pays" to trade at 8% we get the following:

(Click to enlarge)

What this table shows us is that there is still some meat on the bone, and the "will pays" still have value. I continue to recommend the "will pay" preference shares of Royal Bank of Scotland. Of these, the series N and series Q have the most potential upside.

But wait, that's not the end of this story. Now we get to look at the old ABN preference shares, which have been "turned off" until next year (as per RBS' release). The same 9% and 8% scenarios run for the old ABNs which are the:

  • RBS-E: 5.90% Non-cumulative Guaranteed Trust Preferred Securities of RBS Capital Funding Trust V (formerly ABN AMRO Capital Funding Trust V,
  • RBS-I: 6.25% Non-cumulative Guaranteed Trust Preferred Securities of RBS Capital Funding Trust VI (formerly ABN AMRO Capital Funding Trust VI),
  • RBS-G: 6.08% Non-cumulative Guaranteed Trust Preferred Securities of RBS Capital Funding Trust VII (formerly ABN AMRO Capital Funding Trust VII).

(Click to enlarge)

This table shows us that the gain to 9% is around 10% - which in and of itself isn't too bad. The gain to 8% - our "current pay" levels and "will pay" assumption is more appealing at a minimum of 21%.

How I plan to trade these:

I will sell my current pays and roll into the "will pays" when they start to pay (keep the income) or combine them in some fashion (depending on levels) and take the capital I committed to the "will pays" and buy the ABNs. This keeps my income flowing and allows me to "roll" the "may pay" trade into the new "may pay - ABN" trade. Income and appreciation without changing net exposure levels.

Bottom Line: I continue to like the RBS preference share trade. For those with a lower risk tolerance, the purchase of the "will pay" RBS preferred stock has both upside and income. For those with a higher risk tolerance, the trade into the "may pay - ABN" trade is attractive.

Disclosure: I am long RBS.

Additional disclosure: long RBS-L, RBS-H, NW-C, RBS-S