Bank debt is certainly not flavour of the month in the financial markets, particularly in Europe where the lingering prospect of a Greek default, combined with political in-fighting, raises the prospect of systematic risk to the European banking system. Liquidity is shrinking in the money markets, forcing the European Central Bank to step in to provide dollars, as US banks became increasingly reluctant to lend to their European counterparts.
Against this backdrop, it's not surprising that senior bank debt is trading at lower levels. But it is in the subordinated sector that the pain is really being felt; falls of of ten or twenty points have been recorded on medium-dated bonds, such as Societe Generale's 5.4% 2018 issue, which now trading at 78p.
Fixed-income preference shares have also been hit. This class of debt sits right at the bottom of the pecking order in terms of seniority, ranking just above the shareholders. The yield on such instruments is higher than that available on senior debt to compensate for this increased risk. But in the circumstances, is it high enough?
Following the most recent sell-off, which has seen the price decline to 98p, the yield on Santander's 10.375 per cent preference share is running at 10.6 per cent. In the not too distant past this instrument, originally issued by Abbey National in 1995, traded as high as 160p, before crashing to half that level in the dog days of the credit crunch.
The main risk is that conditions for Santander will deteriorate to the point where the company is no longer able or required to pay the coupon. This has already happened to some (but not all) Lloyds TSB preference share holders. Dividends from this instrument will also be subject to a 10 per cent witholding tax.
|SANTANDER 10.375% PREFERENCE SHARES (SAN)|
|Redemption date||Perpetual||Issue size||£200m|
You have to have nerves of steel to buy bank paper in the current environment, but there comes a point where a sufficiently high yield makes the risk/reward ratio attractive. While I suspect the price on these prefs may drift lower, bargain hunters should remain alert given that net yields are nudging double digits. These shares are also non-callable, so there is upside gearing to any recovery.
Bond of the week is supplied by www.fixedincomeinvestor.co.uk and is subject to their disclaimer.