A closer look at the Royal Bank of Scotland
The Sterling Report
AS Jamaican institutions seek to provide investors with higher returns and safer products, a growing appetite for corporate bonds has emerged. One of the recently advertised securities was an Royal Bank of Scotland (RBS) instrument with a fixed to floating rate coupon. Let’s take a closer look at this particular structure and issuer.
This instrument shares many features with a standard “noncumulative preference share” and is actually classified as such in RBS’s capital structure. However, the security is more commonly referred to as a “hybrid”. We’ve spoken about hybrids in previous articles, but here’s a little refresher. A hybrid is a security which combines features of debt and equity. While they are frequently referred to as “bonds”, they have equity-like features that expose investors to different types of risks. It is very important for investors to be aware of these different features and their inherent risks. For example, hybrids usually have very long tenors or no fixed maturity date. This RBS security was issued in 2007 and matures in 2049, giving it a 42-year tenor. In some cases, the issuer reserves the right to suspend interest payments (and even stop accruing interest on the securities). These conditions are usually triggered when the issuer is under financial stress and is in danger of breaching a regulatory capital requirement. In the case of this RBS security, the company stopped paying interest between April 30, 2010 and March 30, 2012 due to European Commission (EC) restrictions which accompanied the disbursement of aid to the entity. This was a consequence of the fact that RBS experienced extensive losses that partially eroded its capital base. In exchange for receiving funding from the EC to bolster its capital base, the company had to restrict dividends to ordinary and preference shareholders. This is not an unusual phenomenon for equity holders, but traditional bond investors accustomed to regular coupon payments should be aware of this feature.
Hybrids also usually have embedded “call options”, i.e. dates on which the issuer can buy the security from holders at a specified price. In the case of this RBS security, the security can be called at any time starting in 2017. The call feature usually works in favour of investors as it acts to reduce the effective life of the security. However, it is important to note that if the security is not redeemed on or before the maturity date, the holder may convert them into ordinary shares in the company at the prevailing market price. This is another interesting feature of hybrids. There are usually provisions that permit either the purchaser or the issuer to convert the security into ordinary shares (or another class of equity) at or before maturity. Hybrid investors should be comfortable with the possibility that they may end up as equity holders at some point during their holding period.
It is also important to understand the ranking of “hybrid” securities relative to that of more traditional debt instruments. In the event of bankruptcy, bondholders are repaid before equity holders. While bonds can vary in the level of repayment seniority in which they rank, hybrid or capital securities almost always rank below the most junior of bondholders. This means that hybrid holders are repaid from the surplus left over after the company has met all its legal obligations. This risk is mitigated by focusing on issuers of high credit quality that are unlikely to default on its debt.
RBS is rated A by S&P and A3 by Moody’s. The implicit comfort in RBS’s debt comes from the fact that the company is 80 per cent owned by the UK Government. RBS is also viewed as a systemically important institution. In other words, it plays an important role in the welfare and functioning of the economy and the market does not believe that the Government will allow the entity to fail. Nevertheless, RBS has improved its fiscal performance and strengthened the viability of its business model since the crisis in 2008/09. RBS’s liquidity position has been improving as evidenced by rising cash balances and deposits. However, profitability remains challenged by sizable loan impairment losses as well as losses on the sale of non-core assets. Management has been actively trying to reduce the risk profile of the bank and is re-strategising its core business in retail and commercial banking. RBS has been able to strengthen its capital base and published a core tier 1 ratio of 10.8 per cent in its 2012 first quarter numbers. Despite RBS’s investment grade credit rating, this particular RBS security is only rated BB as a consequence of the additional risks that are inherent in its legal structure.
Hybrid instruments generally attract higher coupons or yields to compensate investors for these additional risks. However, for the most part, they are a good way to take advantage of higher rates without taking on additional credit risk that may threaten your capital. In sum, it is very important that investors understand the terms and conditions that govern these instruments to ensure that they are within their risk appetite.
Marian Ross is a business development officer at Sterling Asset Management. Sterling provides financial advice and instruments in U.S. dollars and other hard currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm
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