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40% Return Idea From RBS Fixed Income Instruments

|Includes: The Royal Bank of Scotland Group plc (RBS)

This article aims to show how to make money from Capital Revolution (my own term) which EU banks will go through in 2014.

The opportunities arise form the new EU banking regulation, namely CRD IV (Capital Requirement Directive IV) that comes into effect on 1 January 2014. In simplification CRD IV will limit the use of grandfathered (issued before 20 July 2011) capital instruments) mainly preferred shares and subordinated instruments) as bank regulatory capital. From 2014 the banks would be allowed to count only 80% of those instruments as bank capital. Each subsequent year until 2022 the limit for recognising grandfathered instruments as bank capital would decrease by further 10% per year.

This regulation in substance will have two capital markets implications:

1. we will see an avalanche of new generation of hybrid instruments called contingent convertible bonds (so called CoCo) to be issued by the EU banks to boos their capital ratios and to replace grandfathered instruments by the banks to reduce its funding costs

2. we will see a waive of buybacks of grandfathered instruments.

When preferred shares cease to be eligible for recognition as bank capital it will remain just an expensive form of debt. There are two main reasons: (NYSE:I) preferred shares have lower seniority than bank debt and therefore investors require higher yield, (ii) preference dividends are paid from after tax profits while debt interest is paid from profit before tax.

It makes no sense for the banks to retain preferred shares if they loose their capital status. The banks will buy them out. The banks will have two options how to buy them - call them at nominal or buy them back at market in LME (Liquidity Management Exercise), which is a sophisticated name for tender offer. The tender offer would in my experience have to be at about 10% premium above market price. It could be in cash or though an exchange offer to Coco instruments. In each case the purchase will be above market price. The trick is to find the right instruments that are most likely to be repurchased.

My most favourite instruments are RBS Preferred Shares Type G, I, E (tickers RBS PRG, RBS PRE and RBS PRI). All three of them are preferred instruments issued by ABN Amro (now called RBS N.V.) before its takeover by RBS plc. They are still in former ABN Amro entity, which has capital ratio of 24.9% as of 30 June 2013. The entity has more capital than it needs to and than is common. These instruments would be candidates for repurchase even now before the new rules and the new rules just give an additional incentive. When the new rules come into effect at least part of those issues would become uncountable as capital. RBS is here therefore in a situation:

- it needs new capital in the UK RBS plc entity

- it has surplus capital in the former ABN Amro entity

- part of this capital can not be counted by capital even in ABN Amro entity

It is very likely that these instruments would be called. The instruments have nominal of 25 USD while trading 21.3 - 21.8 USD. If called at nominal the investor would make 15% premium to current market prices. Meanwhile the instruments yield around 7% p.a. If you assume that the instruments would be called in the first half of 2014, than the total return would be around 20%, which is 40% annualised return. Not bad for fixed income investment.

Disclosure: I am long RBS.

Additional disclosure: I am long all the instruments mentioned in the article