Preference shares aren't supposedly to soar and plunge like regular equities.

One of the unusual opportunities thrown up by the financial crisis were the stricken preference shares of certain High Street banks.

These once solid income-paying securities – or their descendants – from Lloyds and Natwest were hit for six in the turmoil.

Brave dumpster divers bought shares at stonking yields of 20% or more, that would theoretically payout forever!

Of course the fear was that those yields would not be sustainable – perhaps because the banks would be fully nationalised.

Note: This is not a recommendation to buy or sell any of the shares I mention. Please see my disclaimer and do you own research. Also, I will sometimes use the term ‘preference shares’ as shorthand to cover the whole gamut of prefs, PIBS, and certain retail bonds. There are important legal and financial differences, so again do your research. This is all just my opinion.

A preference for income

A few years on and things look far rosier, in the main.

Certain Lloyds prefs – tickers LLPC and LLPD – were barred by the European legislator from paying their dividend for a couple of years, as a result of that bank being bailed out by the State. But they’ve since resumed payments and prices have recovered strongly, as have the preference shares of Natwest – ticker NWBD – which never stopped paying, despite its parent RBS’ woes.

True, there was a reminder last summer of the earlier uncertainty. Owners of various Co-Op high yield securities got pulled pillar to post as the scale of under-funding at the run-by-mates Co-Op Bank was revealed. An impressive grassroots campaign eventually secured them a pretty decent deal though, and the wider fixed income universe bounced back.

And I noticed this week more bouncing in some of the preference shares and bonds I still hold.

Alas not the floating rate ones I wrote about in January, which are doomed to look like awful investments until the fateful day the bank rate soars to 2%. (Then they’ll look brilliant! Really!)

Rather there’s strength in the likes of the Lloyds preference shares, and the Bank of Ireland subordinated bond with the ticker BOI.

My first thought on spotting this was that the wider markets were selling off on the Crimean ruckus, and a few nervous investors were buying bank preferences shares instead.

These shares are very illiquid, so this idea isn’t as fanciful as it seems. While they shouldn’t be thought of in the same breath as government bonds – they are far, far riskier and in a true meltdown will sell-off much like equities – as the financial crisis recedes they will be governed more by interest rates.

I’m now pretty sure though that the real reason is Lloyds’ recent tender offer to buy back its Enhanced Capital Notes (ECNs).

Tender is the plight

Lloyds’ ECNs were created in 2009 as the bank scrabbled about for capital in the midst of the banking crisis.

Regulators have seemingly had a change of heart since then, and there is talk the notes may not count as core capital if the bank gets into trouble, or even in a stress test.

The upshot is Lloyds apparently doesn’t want them hanging around on its books. It’d rather buy them up now and replace them with something more pleasing to the regulator.

I’m being deliberately colourful in my description here because I’m not any sort of expert on these ECNs and I don’t want to mislead you with spurious precision.

In fact, I’d suggest holders have a read of the relevant thread on the clued-up Motley Fool banking board. Or, if you find that’s too confusing – and I wouldn’t blame you – then there are write-ups at ThisIsMoney and Reuters, among others.

The latter articles outline the thinking of Mr Mark Taber, who has become the unpaid champion of the Little Guy in these situations. (He’s also in that Fool thread, posting under the name OldBoyReturns). He reckons Lloyds is behaving unfairly to retail investors1.

I didn’t really agree until I read more deeply into the Fool discussion. The tender offer is optional, for starters, so my first thought was how coercive can it really be? But on reflection there does seem to be a reasonable argument that the bank has handled things clumsily (some allege worse) and that private investors are being asked to make a decision that they aren’t well-equipped to make.

There’s an estimated 120,000 retail investors holding these ECNs. How many of them are reading the latest newspaper articles, let alone in-depth discussions like the one on the Motley Fool?

A fraction of a fraction I’d have thought.

You might save caveat emptor – except the roots of these notes can stretch back to PIBS first issued when Lloyds-owned Halifax was a building society and I was in short trousers.

PIBS were a class of investment that was often touted as ideal for widows and orphans, as opposed to being touted at City slickers. Yet these unsophisticated holders are now being asked to decide whether to tender.

Retail investors not wanted?

Interestingly, Taber also believes the powers-that-be have decided everyday investors like you and me shouldn’t hold these sorts of bank securities at all.

Apparently that’s why the Lloyds tender doesn’t enable retail investors to swap their ECNs for new bond-like securities, only cash.

On the one hand, a glance at the tender announcement for the ECNs seems reason enough to agree that Joe Public shouldn’t be going anywhere near them. Their potentially confusing nature when things get sticky is implicit in most critics’ objections to the tender, after all.

Also, it’s clearly not in the authorities’ interest to have supposedly loss-absorbing capital that turns into a PR disaster whenever old people or photogenic mothers-of-three are the ones taking the loss. Better such cannon fodder is in the hands of banks and institutions who are unlikely to get much sympathy in a crisis.

Yet on the other hand, we are allowed to own ordinary shares in banks. And it’s often forgotten that equities are the riskiest tranche of capital of all.

So there does seem to be potentially something odd going on, if it’s true that we’re being quietly steered away from non-equity investments in banks.

Falling yields: Consol yourself

Anyhow, the point for bank preference shares is that I suspect people are buying them as a result of this brouhaha.

They may be buying them as a replacement for the income stream they’re selling with the ECNs, or they may be buying because the perpetual nature of these bank preference shares suddenly looks a lot more attractive. Or they may be buying because they think those things will occur to others soon enough!

Whatever the reason, it could present preference share holders with a difficult decision if prices keep rising.

Really, preference shares should be priced off a spread over their yield versus perpetual government bonds – gilts – such as Consols or War Loan2. This spread should reflect their much greater riskiness, compared to gilts.

And sure enough the spread has been narrowing as people have gotten happier that the issuing banks are more secure. But it’s still not quite as tight as before the financial crisis.

War Loan is yielding about 4.2% at the moment, while the Lloyds preference share LLPC is yielding around 6.7%. The spread is thus around 2.5%. From memory it was as narrow as 1.5% before the crisis3.

Now, I’d argue the big banks are a much safer bet than pre-2008, although as a shareholder in Lloyds I’m possibly biased. And while there is certainly more regulatory risk than before, this is more of an issue for owners of the common shares than the preference shares.

Tougher rules make the banks less lucrative in terms of return on capital, say, but they are a positive for the preference shares, since preference share dividends must be paid before the common shareholders get a penny. So they don’t need such strong earnings to see their income streams maintained.

Slim pickings?

For these reasons, exactly what’s a sensible spread over a perpetual gilt is hard to judge. If it got much below 2% though, I suspect I’d let others have mine.

It’s worth making your mind up as to what level of spread, if any, would be a sell for you if you own these preference shares. And then to watch them carefully!

If even a fairly small number of those 120,000 ECN owners start throwing money at bank preference shares, the spread could narrow sooner than we’d think. But equally, their impact on prices might not last.

A perfect set-up for us active investors to tie ourselves in knots over.

Note: I own holdings of several of the preference shares cited in this article.

  1. Retail investors are ordinary people like you and me, as opposed to institutional investors.
  2. Note: These issues could theoretically be called by a government, and hence are not truly perpetual. But they never have been, and the market treats them as if they won’t be.
  3. Or rather that was the spread on the old Halifax issues that these preference shares descend from.

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