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An Aggressive Preferred

May 18, 2011 1:23 PM ETNWG
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Seeking Alpha Analyst Since 2011

David Landes is the founder and CEO of BondsOnline Group, Inc. a suite of financial information and data websites for fixed income investors, and financial professionals. The sites, BondsOnline.com, PreferredsOnline.com, BondsOnlineQuotes.com, and Ratecurve.com provide levels of data and analytics suitable for individual investors seeking "Income Investor Tools", and for tax and valuation professionals seeking specific benchmark valuation data. Yield and Income Newsletter provides monthly surveys of income opportunities for investors. The company, and I, also developed and sold an e-commerce network for municipal bond issuers and underwriters to transact new issue origination, used by all major participants in the municipal bond markets. When not focusing on business, I am involved in guiding development of bicycle pathways and trails in Jackson Hole, WY and in avalanche forecast activities in the Tetons and surrounding mountains, and in using the recreational features of the area.

Preferreds trading at a premium to par (usually $25) these days are hiding pretty dismal returns if the securities get called. (In fact, many offer yields below what floating rate preferreds are offering today). That’s why Yield to Call becomes so important.

 Although preferreds are considered a relatively safe, moderate return investment, aggressive investors may like to look at an interesting idea:
Royal Bank of Scotland was one of the hardest hit global banks during the financial crisis, leading other European banks in total losses ($70bn) and total capital raised ($95bn). Since then, RBS has embarked on a strategic initiative of disposing non-core assets and seems to be progressing well with its restructuring plan. Despite a first quarter loss, the bank was profitable in 2010 and is regarded as making progress. Speculation has been surfacing about how, and when, Britain may start unwinding its 83% stake in the bank.

Royal Bank of Scotland Group plc (RBSG) is the main holding company. Most of the company's senior unsecured debt, however, is issued by Royal Bank of Scotland plc (RBS), which is the main operating banking subsidiary.
RBS has senior debt and subordinated debt outstanding, both ranking ahead of its preferreds: coupons must generally be paid on subordinated debt if the bank is making dividend payments on their preferreds or common shares. Barry McAlinden of UBS Wealth Management stated in a report to customers dated February 8, 2011 that he believes RBS subordinated debt will be "money good" at maturity and the risk of principal losses is low.
If that is the case, then it’s time to look down the ladder at the preferreds. Royal Bank of Scotland, RBS, has 14 different preferreds, and each has a different dividend status.
Most of the $25 par preferreds outstanding are structured as non-cumulative. Preferreds with symbols RBS pr M, N, P, Q, R, S, and T had their dividends suspended for two years on 30 April 2010 due to the European Commission's burden sharing restrictions placed on financial institutions. These securities last paid dividends on 31 March 2010.
On August 31, 2010, the European Commission ruled that starting in April 1, 2011 RBSG would not allow RBS topay dividends  for two years on RBS pr E, G, and I. (Several other series of preferreds are considered “must pay” that only allow for suspension provided that specific capital requirements and distributable profits tests are breached).
On a longer term basis, if RBS is eventually able to operate as a profitable stand-alone institution without government ownership, UBS has stated that it believes “dividends would be reinstated when their respective coupon bans are lifted in 2012 and 2013.” This means that even though dividends are non-cumulative, prices would move closer to par as the market anticipates resumption of dividend payments. (In fact, the charts below show this trend).
Consider one series:RBS prS is now trading at $18.85. If the bank resumes dividends on March 30, 2012, and if the markets anticipate it, the price will increase toward $25, generating a total return of perhaps 30%. Or, if rates stay low, the bank may be able to tender or exchange some high coupon preferreds on or after March 30.
The risks are (1) that interest rates spike before then, making the 6.60% yield look weak to other comparable preferreds, or that RBS hits a bump before March 2012, or March 2013 for series E, G, I, and can’t resume payment of dividends.

If you like the outlook for the parent company, RBS, then the forecast for the price appreciation makes sense.
Disclosure: we have direct and indirect positions in RBS prQ.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: I have direct and indirect positions in RBS prQ.

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