There is already a precedent for issuers of PIBS not redeeming. Principality Building Society did not exercise the call on its 5.375% PIBS (PBS) in July 2011 and, as a result, the current coupon is just 2.035%. So the 'non-call' issue is definitely a factor but not one which applies to the majority of PIBS in issue. Of the 39 issues of PIBS and former PIBS listed in the PIBS Prices page of this website only seven have a call date falling within the next 5 years as follows:

Of these two issues (Nationwide's NABA and Ones Savings Bank 1SBB) have reset rates of at least 4% above the reference rate which makes them more likely to be called on an economic basis even if interest rates to stay at current low levels. There is also the question of whether Nationwide, which prides itself on being the strongest of the remaining mutual building societies, will continue to exercise calls in accordance with the 'gentleman's agreement' for reputational reasons. Whatever happens in the case of the small minority affected the majority of the 39 issues on my list should not be tarred with the same brush as, in many cases, they are perpetual with no issuer call option and no coupon change.

The same factor of issuers not exercising calls also applies to large number of Tier 1 subordinated bank bonds. While it is certainly a factor to be taken into account in considering potential investments I do not think investors should be bemoaning the behaviour of issuers. They are acting in accordance with the terms of the contract they entered into which is how it should be. What is not acceptable, in my eyes, is political interference to change the terms of private contracts entered into between financial institutions and private individuals or companies. We have seen this happen in the base of Irish bank bonds and, even to a certain extent, in the fiasco over Steven Hester's bonus.

While on the subject of PIBS I have received the following email from an investor concerning One Savings Bak plc PSBs (former Kent Reliance PIBS):

Also, I am working on a project to provide a platform for retail investors in fixed income securities to buy or sell and avoid the horrendous spreads currently quoted in the market. It cannot be right that a bond yielding 9% has a spread which would eat up the first 2 years of interest received by a buyer and it is not surprising that the market in many issues is very illiquid as a result. If this project is of interest to you I would be very grateful if you could complete a short survey I am doing at Fixed Income Order Book Survey

I thought I would start 2012 by taking a look at the main factors likely to affect subordinated bonds and preference shares during the year. With the combination of the Eurozone crisis, the advent of Basel 3, the recent raft of tender and exchange offers by issuers, the changing landscape with respect to calls and the prospect of discretionary coupon resumption by large issuers such as Lloyds and RBS there are plenty of dynamics to consider when looking for investing opportunities !

There was a flurry of tender and exchange offers for subordinated securities by UK and Eurozone banks towards the end of 2011. Market reaction was mixed with the exchange offers, into lower coupon senior notes, by Santander and BNP attracted particular criticism from institutional investors. The main offers are summarised below.

15 Nov 2011: Santander announced a controversial exchange offer in relation to €6.8 billion of LT2 securities. Offer was to exchange, with exchange ratios ranging from 87% to 99.5%, into new senior securities with substantially lower coupons. The offer was criticised by institutional holders and the ABI bondholders committee. The acceptance rate was low at about 24%.

17 Nov 2011: BNP announced an exchange offer in relation to $4 billion of Tier 1 and Tier 2 securities. The offer was to exchange into new senior floating rate securities. The acceptance level was about 38%.

18 Nov 2011: Societe Generale announced a cash tender offer for up to €1.4 billion of its Tier 1 securities.

1 Dec 2011: Lloyds Banking Group announced an offer to exchange £4.9 billion of LT2 securities into new LT2 securities with longer maturity at exchange ratios of between 70% and 80.75%. The acceptance rate was about 61%.

5 Dec 2011: Commerzbank announced a cash tender offer for €2.23 billion of its Tier 1 securities at between 40% and 52.5% of nominal.

5 Dec 2011: Barclays announced a cash tender offer for £2.5 billion of its Tier 1 securities at between 70% and 94.5% of nominal.

12 Dec 2011: ING announced a cash tender offer for €5.8 billion of its subordinated bonds at between 58% and 87% of nominal. The acceptance rate was about 60%.

The focus has been been to take advantage of depressed market conditions to generate Core Tier 1 capital through repurchase or exchange of Tier 1 and Tier 2 securities at a discount to nominal. Offers have been targeted at institutional issues. Issuers have not tended to include higher coupon Tier 1 issues in these offers. Barclays, for example, did not include its 14% perpetual tier 1 notes in its tender offer. This would not have generated capital in the same way but would have reduced the level of expensive subordinated debt.

It will be interesting to see the approach issuers take moving forward and, in particular, whether Lloyds and RBS tender for their Tier 1 and UT2 bonds and preference shares. It appears that Lloyds is currently prevented from taking this approach due to the repurchase restriction on the terms of many of its securities currently affected by the EC coupon suspension commitment. This will be a frustration for them especially as the restrictions could limit their ability to tender well beyond the 31 January 2012 date at which the suspension commitment expires. For example the three high coupon Lloyds 13% perpetual tier 1 securities impose a repurchase restriction across all parity securities for a period of 1 year from the last coupon deferral. With the interest date of 21 January 2012 caught in the suspension period this would imply an earliest date of 21 January 2013 for any repurchase unless Lloyds and their legal advisers can find a way round the problem.

Basel 3 will take effect from 1 January 2013. It seems that virtually all existing Tier 1 securities and preference shares will not count as Tier 1 under Basel 3. For those who like the detail below is a list of the 14 criteria laid down for inclusion in Additional Tier 1 Capital Under Basel 3:

1. Issued and paid-in.

2. Subordinated to depositors, general creditors and subordinated debt of the bank.

3. Is neither secured nor covered by a guarantee of the issuer or related entity or other arrangement that legally or economically enhances the seniority of the claim vis-à-vis bank creditors.

4. Is perpetual with no maturity date and no step-ups or other incentives to redeem.

5. May be callable at the initiative of the issuer only after a minimum of five years providing:

        a. To exercise a call option a bank must receive prior supervisory approval; and

        b. A bank must not do anything which creates an expectation that the call will be exercised; and

        c. Banks must not exercise a call unless:

                i. They replace the called instrument with capital of the same or better quality and the replacement of this capital is done at conditions which are sustainable for the income capacity of the bank; or

                ii. The bank demonstrates that its capital position is well above the minimum capital requirements after the call option is exercised.

6. Any repayment of principal (eg through repurchase or redemption) must be with prior supervisory approval and banks should not assume or create market expectations that supervisory approval will be given.

7. Dividend/coupon discretion:

        a. the bank must have full discretion at all times to cancel distributions/payments

        b. cancellation of discretionary payments must not be an event of default

        c. banks must have full access to cancelled payments to meet obligations as they fall due

        d. cancellation of distributions/payments must not impose restrictions on the bank except in relation to distributions to common stockholders.

8. Dividends/coupons must be paid out of distributable items.

9.      The instrument cannot have a credit sensitive dividend feature, that is a dividend/coupon that is reset periodically based in whole or in part on the banking organisation’s credit standing.

10.    The instrument cannot contribute to liabilities exceeding assets if such a balance sheet test forms part of national insolvency law.

11.    Instruments classified as liabilities for accounting purposes must have principal loss absorption through either (i) conversion to common shares at an objective pre-specified trigger point or (ii) a write-down mechanism which allocates losses to the instrument at a pre-specified trigger point. The write-down will have the following effects:

12.    Neither the bank nor a related party over which the bank exercises control or significant influence can have purchased the instrument, nor can the bank directly or indirectly have funded the purchase of the instrument.

13.    The instrument cannot have any features that hinder recapitalisation, such as provisions that require the issuer to compensate investors if a new instrument is issued at a lower price during a specified time frame.

14.    If the instrument is not issued out of an operating entity or the holding company in the consolidated group (eg a special purpose vehicle – “SPV”), proceeds must be immediately available without limitation to an operating entity or the holding company in the consolidated group in a form which meets or exceeds all of the other criteria for inclusion in Additional Tier 1 capital.

These criteria, and particularly item 11 which introduces a requirement for principal loss absorption prior to insolvency, will mean that old Tier 1 securities will no longer qualify under Basel 3. In respect of such securities Basel 3 makes the following statement:

The last sentence above tells us that those issues with an incentive to redeem will stop qualifying as Tier 1 or Tier 2 capital, respectively, at the first call date, and, as a consequence, there is a strong incentive for the issuer to redeem those bonds. For bonds with first call date later than end 2012, but without an incentive to redeem such as a step-up, the capital recognition will be reduced by 10% each year starting from 1 Jan 2013. This seems to provide an incentive for issuers to tender for bonds with long-dated first calls, unless there is a regulatory call option available to force early redemption.

However, I do not think that this means that issuers will automatically seek to repurchase / exchange non-qualifying ‘grandfathered’ securities at the earliest opportunity. Irrespective of Basel 3 they are still a source of finance and, therefore, I think issuers will only seek to repurchase / exchange them where it makes commercial sense for them to do so. The key drivers here will be the cost of the securities and the nature of the holders. Issuers seem to be appreciating that dealing with retail held securities is problematic when it comes to exchange offers or coercive tender offers and so I would expect these to tend to be spared from anything other than voluntary cash offers. However, I would not be surprised to see ‘sweep up’ clauses used in tender offers (similar to those in the recent Bradford & Bingley and NRAM tenders) such that if there are sufficient acceptances the remaining bonds get called on the same basis as those accepting. Unless terms are very generous I would not expect high acceptance levels and so the remaining issues should be large enough to provide liquidity.

As we saw in early 2009 when the market gets very nervous about the solvency or liquidity of banks the market for their subordinated debt can be hit very hard and subject to indiscriminate selling at any price. The current Eurozone crisis has the potential to cause a similar situation and, consequently, the question of whether or not to buy bank subordinated debt right now entirely depends on how the Eurozone crisis evolves. If the situation deteriorates, and one or more Eurozone countries default and/or leave the Eurozone, then the resulting panic could force emergency public sector recapitalisation of a wide range of Eurozone banks. In these circumstances, market prices of bank sub debt would certainly fall further. Furthermore, as we saw in Ireland in 2011 if times get desperate enough, governments will find ways of imposing losses on holders of bank subordinated debt to provide part of the rescue capital for the banks concerned.

In my opinion the UK banks are in a much stronger balance sheet and capital positions than most Eurozone banks. So in that sense their subordinated debt is safer and UK banks could even be seen as a safe haven relative to those in the Eurozone. But ultimately, if the Eurozone crisis becomes bad enough, it will hit the UK banks badly too and they will need additional capital. If that has to come from the government, then there is a significant risk that holders would be coerced into accepting significant losses whatever the legal terms say.

While the Eurozone crisis is ongoing my view is to concentrate on the subordinated debt and preference shares of UK issuers. However, specific distressed or value opportunities may appear in Eurozone banks and where this happens my preference will be to seek out securities issued by UK subsidiaries of these banks with the terms under English law and the jurisdiction of English courts.

In my view the convention of issuers calling securities on the first call date is a thing of the past. Deutsche Bank started the new trend back in 2008 when it did not call one of its subordinated bonds and in Feb 2011 Italian bank Monte dei Paschi di Siena did likewise.

Amongst UK banks and building societies issuers such as Lloyds and RBS have given commitments to the EC not to exercise calls during the 2 year EC coupon suspension period. Then on 23 June 2011 Principality Building Society announced that it would not exercise its call option on the 5.375% notes 2016 (PBS) on 8 July. This was the first call due amongst PIBS and subordinated bonds popular with retail investors and the fact that a non-distressed issuer decided not to call its bond is significant. 

Then on 15 September 2011 Barclays elected not to call one of its USD T1 preference shares (US06739F3901). It is a $750M issue and the coupon is 6.625% with no reset on the call date. The explanation given by Barclays investor relations for this non-call was:

Most calls of T1 securities of UK banks are subject to FSA approval and it could well be that the FSA are reluctant to approve calls of large issues in the current climate. If other building societies or banks decide not to call their PIBS or bonds, the impact on value could be serious, especially in cases where the coupon is reset against currently low LIBOR rates.

Going forward I think issues with call dates will only be called if the issuer can refinance cheaper elsewhere. With reference rates (such as LIBOR) so low many issues which revert to LIBOR + x% look unlikely to be called in the current climate. I do not think reputation or convention will come into these decisions in future.

The exception could be larger issuers such as Lloyds using call options to tidy up the relatively small rumps of securities which are largely retail held. Obvious examples here are the rumps of issues of Lloyds preference shares with call options which were not tendered for ECN exchange back in 2009.

However, as already mentioned, Basel 3 gives a clear direction for issuers to exercise calls on issues where there is an incentive to do so (such as ‘step-up’ issues) so I would expect such issues to be called at the first call date. This could give rise to some interesting investment opportunities amongst T1 securities trading at a discount to par but with a near term call and high reset rate.

Discretionary coupons on Lloyds and RBS subordinated bonds and preference shares are currently subject to two year suspensions under a commitment given to the EC as a condition of State aid approval. The Lloyds suspension expires on 31 January 2012 and there has been much debate over whether the bank will resume discretionary coupons at the earliest opportunity thereafter.

I have been doing some New Years research on this question which resulted in a long conversation with the Head of Debt Investor Relations at Lloyds. The coupon suspended security with the first payment date after expiry of the suspension is the 7.375% Euro 2012 issue (ISIN XS0107222258). This issue has an interest payment of 7 February 2012 which also happens to be the first call date. He told me that Lloyds has issued a call notice in respect of this security. I made the point that this does not appear to be an economic call (the reset is 3m Euribor + 2.32%). The answer was that it is a small rump and the holders' option to force redemption using an ordinary share issue was a complication they prefer to avoid. I also pointed out that the call appears to breach the redemption restrictions in the terms of various coupon suspended securities. Answer was that they have been working with Trustees of various issues to put measures in place (such as setting aside next 12 months coupons in Escrow) to work around this.

He made the point that switching back on the coupons following the suspension was very complex (and much more difficult than switching them off) and the inter-play of the various terms causes some circular situations. As a result they have had to work with the Trustees of a number if securities to obtain waivers of conditions in return for setting aside of funds to cover coupons.

I made the point that the market could do with some communication as to what was going on - especially due to the issue of pricing of accrued interest. He very much took this point on board and said they would work on it and look to get announcements out before the end of the 31 January EC suspension.

Overall the impression I got was that Lloyds is very much preparing to resume payment of discretionary coupons once the EC suspension period expires.

Another issue which arises out of discretionary coupon resumptions is what will happen about the unpaid deferred interest from the suspension period on cumulative securities? In the case of UT2 securities such as Lloyds 'H' Series (tickers HALA, HALC, HALP and HALB) subordinated bonds the terms require that such accumulated interest be paid before dividends can be paid on any junior share capital. I would, therefore, expect Lloyds to pay the deferred interest on these securities on the first payment date following expiry of the suspension period. However, there are some perpetual T1 securities (such as the Lloyds 13% Series) where the cumulative terms are less strong and do not give as much comfort to holders. In the case of the Lloyd's 13's deferred accumulated interest only becomes due on redemption or winding up. Due to the perpetual nature the securities may never be redeemed and, so, in theory the deferred interest may never become paybable. There is also the issue of the Alternative Coupon Settlement Mechanism (ACSM) in the terms of the 13's which requires that payment of deferred interest is funded by the issue of ordinary shares. This may also deter Lloyds from settling the interest sooner as it adds a layer of hassle which, presumably, would need the FSA's blessing to avoid. However, due to the high coupon and step-up after the 2019 /2029 (depending on issue) first call date the 13's are highly likely to be called. The combination of the high coupon and long-dated first call also make the 13's prime candidates for a tender offer at some point this year and Lloyds may well see some value in holding back the deferred so that it can be offered as a carrot to holders in an offer. 2029 is rather a long time to wait so holders may want to consider pushing Lloyds to pay the deferred interest once interest payments resume. I understand from Lloyds that no decision has yet been made on this.

Well those are my thoughts for starting 2012. In the short term they will lead me to scour for securities, likely to be T1, issued by UK banks (or UK subsidiaries of foreign banks) trading at a healthy discount to nominal, a reset rate which steps up rather than down and either a first call date in the next few years or an incentive to tender due to the high coupon.

As always I welcome the thoughts of others so please share your views by emailing me at mark@fixedincomeinvestments.org.uk

I have recently set up a Twitter page which I plan to use in future so if you use Twitter please add me to those you follow. My page is at Follow @MarkTaber_FII

The mechanism being used is similar to that used by Irish banks in their tender offers. This is that the issuers are seeking to amend the terms of the bonds to insert a call option. The process is eased along by those who accept the offer being deemed to cast a vote in favour of the amendment resolution in the process. However, unlike the coercive Irish offers, the proposed call option in the Bradford & Bingley and NRAM offers is at the same rate as the offer itself. So at first glance not accepting the offer and voting against the amendment resolution if you are not happy with the level looks a reasonable option if the call option were to be exercised immediately the amendment resolution was passed. However the sting comes in the risk warning attached to the call option which states:

The question of whether or not Lloyds Banking Group will resume coupon and dividend payments on its discretionary preference shares and hybrids when the EC suspension ends on 31 January 2012 has been hotly debated by investors for some time now. Lloyds have been non-committal on the subject until now with the official line being:

However, this week the bank released its Interim Management Statement which included the following statement:

This is because new European Banking Authority stress tests have revealed that European banks need to raise €106 billion of high quality capital to withstand potential writedowns on their holdings of the sovereign debt of countries such as Greece, Spain, Italy, Portugal and Ireland. Worst hit are Spanish and Italian banks which the European Banking Authority estimates require 26.2 billion euros and 14.8 billion euros of extra capital respectively . It gave them until 25 December to submit capital-raising plans to national supervisors.

Regular users of this site and followers of my Bank of Ireland 13.375% Subordinated Bonds Campaign will be more than familiar with the Irish model for raising Core Tier 1 capital from junior bondholders. It relies upon creating a prisoner's dilemna a type situation whereby bondholders are offered a percentage of the face value of their bonds in cash or shares but, in accepting, they are required to give a vote in favour of a devaluation resolution to amend the terms of the bonds. The amendment is to grant the issuer a call option whereby the bonds can be called at 1c in 1,000 Euros. Hence the dilemna - either accept a haircut and vote to wipe out those who do not or not accepting risk being wiped out by the votes cast by those who do ! There is a third option of challenging the legality of the devaluation resolution in under English Law (the law of choice for most European bonds). However, despite legal opinions suggesting that the case against the use of devaluations is strong the institutional holders with the might to pursue it elected to keep their heads below the parapet and accept their fate instead. This is a decision which may well come back to haunt them if the Irish model is applied by other European banks in the coming months.

 

 

ii.    That the Scheme was affecting a substitution of the issuer without a guarantee from Bristol & West as was required by the Trust Deed.

iii.    That the only remedy available to the Trustee and bondholders, being obtaining a winding up of the issuer, was being moved from English Law in English Courts to Irish Law and Irish Courts. This change struck at the heart of the Trust Deed and rights of bondholders and was clearly materially prejudicial to their interests.

iv.    That the Trustee had not approved the scheme nor any of the above despite the requirements of the Trust Deed for it to do so and the limitation of approval to matters which are not materially prejudicial to the interests of bondholders.

v.    That insufficient notice (6 days) of the High Court Scheme of Arrangement was given to bondholders.

vi.    That neither the Notice which was sent to bondholders nor the Explanatory Statement disclosed the majority of the material changes which would affect the position of the bondholders.

vii.    That the FSA does not seem to consider that it had any duty to consider the interests of bondholders.

I am involved in ongoing correspondence with the FSA on these issues and have attempted to summarise the key documents and correspondence below for those who are interested: 

 

 

 

 

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http://archive.treasury.gov.uk/fsma/business_transfers/order.pdf 

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26 June 2011

Email: mark@fixedincomeinvestments.org.uk

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RESPONSE TO FSA NOTE ON BANK OF IRELAND BRISTOL & WEST BONDS

6 July 2010

I am writing on behalf of holders of Bank of Ireland former B&W PIBS in response to the FSA’s note which attempts to explain its involvement and responsibilities. We believe that the note contains a number of inaccuracies concerning events and omits certain relevant information in relation to the FSA’s role. In view of the fact that the Bank of Ireland has announced that it intends to make another offer to holders of the notes it is vital that the FSA reviews and acts upon the points raised below without delay.

1. Paragraph 3 of the note characterises the securities as ‘Subordinated Capital Instruments.’ It should be noted that they were issued as PIBS by Bristol & West Building Society in 1991. Distribution was via a placing agent (Hoare Govett) and we have substantial evidence to suggest that they were largely sold over the counter to customers of various building societies as a safe product. It should be noted that since this time bondholders have not been given the opportunity to approve or vote on any changes to the issuer, the terms of the notes or their rights.

2. Paragraph 15 of the note states that the greater risk of the notes is reflected in the higher return. The majority of current holders either acquired the notes at issue or inherited them. At the time of issue (in 1991) the coupon of 13.375% was not a high risk rate. Interest rates were much higher then and UK Government Gilts were issued that year with a 12% coupon. So a 13.375% is not substantially higher than the risk free rate at the time and would not have indicated a high risk product to investors.

3. Paragraph 8 of the note states that there are 2,636 known bondholders. We believe that this refers to the number on the register. However, this includes nominees as single entries whereas many broker’s nominees will include hundreds of individual holders. We are in touch with over 500 such holders so that actual number is well in excess of 3,000.

4. Paragraph 8 of the note states that holders £52M of the £75M outstanding would have been eligible for the 40% Equity Offer and £23M for just the 20% cash offer. This is not consistent with the evidence we have. The terms of the offer required individual beneficial holders to have a holding of at least £110,000 nominal and required a separate exchange instruction from nominees in respect of each individual beneficial holder. Only a very small number of holders would have qualified for the Equity Option on this basis. It should further be noted that the terms of the notes only permit repurchase by tender open to all holders alike. The decision not to prepare a prospectus to give access to the Equity Offer for smaller holders was therefore a breach of the terms of the notes.

5. Paragraph 5 of the note states that the Bank of Ireland had to ensure that information regarding the change of issuer was made public for shareholders and bondholders in accordance with UKLA requirements. It further refers to a Prospectus, approved by the UKLA, as part of this process. We would draw your attention to the following timeline:

6 June – RIS announcement made (see ‘Noticed’ attached) concerning the Scheme of Arrangement. Note that under the terms of the bonds all notices to bondholders must be communicated in writing by post and so this was not valid service under the terms or the Listing Rules.

14 June 2007 – Scheme of Arrangement document produced (see ‘Scheme’ attached) for approval by the Court. This was not communicated or made available to bondholders. Note that this document makes no reference to the number and nature of holders of the 13.375% bonds nor does it disclose the following fundamental issues:.

i. That regulatory protection was being moved from the UK (FSA) to the Irish Regulator.

ii. That the Scheme was affecting a substitution of the issuer without a guarantee from Bristol & West as was required by the Trust Deed.

iii. That the only remedy available to the Trustee and bondholders, being obtaining a winding up of the issuer, was being moved from English Law in English Courts to Irish Law and Irish Courts. This change struck at the heart of the Trust Deed and rights of bondholders and was clearly materially prejudicial to their interests.

iv. That the Trustee had not approved the scheme nor any of the above despite the requirements of the Trust Deed for it to do so and the limitation of approval to matters which are not materially prejudicial to the interests of bondholders.

11 September 2007 – Notice of Court hearing on 17 September 2007 posted to bondholders ( see ‘Transfer’ attached). This notice did not contain any information about how the transfer would affect their position and only referred them to an Explanatory Statement (see ‘Statement’ attached) which they had to obtain separately. There is no reference in the notice to the UKLA approved prospectus referred to in the FSA’s note. Furthermore the notice required them to file any representations or desire to attend the hearing with the Bank’s lawyers with only a postal address being given. Allowing for postal service and non-business days holders were only given 2 days notice of the hearing. This was a breach of the requirements under the Trust Deed and the Listing Rules. It was also completely unreasonable considering the number and nature of holders.

17 September 2007 – Court hearing at which the transfer was approved.

24 September 2007 – FSA approves the Supplementary Prospectus (as stated in Paragraph 10) of the FSA’s note. This was after the Court had approved the Transfer and so the Prospectus served no purpose in communicating what was proposed to bondholders. Furthermore neither the Prospectus, nor its existence, was communicated to bondholders.

6. Paragraph 16 of the note states that the FSA, acting as the UKLA, did have responsibility to ensure that Bank of Ireland publicly made available information to bondholders regarding the change of issuer in 2007. Further, that the Bank of Ireland issued a prospectus to bondholders regarding the change and the UKLA has received no evidence to show that the Bank of Ireland did not meet its requirements. The information and dates provided in point 5 above clearly demonstrate that the UKLA failed in its responsibility and that the Bank of Ireland did not meet its requirements.

7. In its capacity as the UK's listing authority (UKLA), the FSA has a regulatory objective to provide an appropriate level of protection for investors in listed securities. The FSA’s own website states that ‘By making and enforcing the Disclosure and Transparency Rules, the Listing Rules and the Prospectus Rules, we aim to protect investors and foster appropriate standards of transparency, conduct, shareholder rights and due diligence.’

From the contents of the FSA’s note, the evidence presented above and the previous experience of the Lloyds Banking Group Exchange Offer in 2009 it is crystal clear that the FSA has failed to make and enforce Rules to provide an appropriate degree of protection to investors in UK listed retail bonds.

In view of the Bank of Ireland’s stated intention we demand that the FSA acts on the above points without delay and makes a statement to holders to confirm that it is doing the same. We also repeat our previous demand that the FSA undertakes and announces an urgent of review of its rules in respect of UK listed retail bonds without delay.

Mark Taber

Email: mark@fixedincomeinvestments.org.uk

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Response from FSA dated 6 July 2011 to 29 June Letter:

 

 

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Letter to FSA 11 July 2011

Dear Mr Sants

Thankyou for your letter of 7 July (copy attached) in response to my letters of 26 & 29 June. Please note that I have not received a response to the ‘Bondholders Response to FSA Note on Bank of Ireland Bristol & West PIBS’ sent by email on 7 July. This raised serious and urgent issues which demand a response.

I would respond to the points made in your letter as follows:

1. In Respect of the Bank of Ireland former B&W PIBS

Your response indicates that the FSA’s involvement has been limited to the approval of the Supplementary Prospectus on 24 September 2007. This is not consistent with the terms of the bonds which required consent of the FSA for substitution of the issuer nor is it consistent with the ‘Explanatory Note’ to which bondholders were referred by the Notice of the 17 September 2007 Scheme of Arrangement. Para 1.5.1 of this Notices states:

In addition to seeking Court approval of the transfer Bristol & West and Bank of Ireland have been working closely with their regulators, the FSA and the Irish Financial Regulator, to help ensure that customers are not adversely affected by the transfer.

As detailed in the Bondholders Response of 7 July bondholders clearly were adversely affected. Furthermore, they were not given proper notice of the Scheme of Arrangement and the Notice, Explanatory Statement and High Court papers failed to disclose the materially adverse changes which were being sought under the transfer. All of these issues must be investigated as a matter of urgency.

I would also remark that the Supplementary Prospectus you refer to was approved by the FSA after the transfer took place and so served no purpose in alerting bondholders to what was proposed. Its existence was also not communicated to bondholders.

It should also be noted that since the Irish Government have retrospectively upended the capital hierarchy through the Credit Institutions Stabilisation Act and use of coercive offers the Supplementary Prospectus is inaccurate and misleading in respect of risks and subordination. The continued failure of the Bank to update the Supplementary Prospectus, on which those investing are entitled to rely, must surely be a breach of the Listing Rules and constitute Market Abuse under the FSAM 2000.

While the Bank of Ireland has terminated its offer in respect of the bonds as a result of our campaign it should be noted that the Bank announced on Friday that it still intends to make a further offer. This is causing continued distress amongst holders of the bonds thousands of whom rely on them for pension income. Furthermore many holders sold their bonds in the market at substantial losses in the panic which followed announcement of the Offer and the date it was terminated. This was a direct result of the Bank deliberately excluding them from the Equity Exchange Offer – something which was a breach of the terms. When questioned about this by holders Brian Keely (the Head of Capital Management at Bank of Ireland) responded:

The cash offer will be open to all holders however the equity offer will only be open to holders who will be entitled to shares valued at the equivalent of €50k (about £44k at present). However if the equity alternative is attractive enough then I would expect that bondholders with bond holdings below the required level to take part in the equity offer may be able to sell their bonds in the market at higher than the cash offer terms to those who want to take the equity offer.

This was clearly a deliberate and highly questionable strategy on the part of the Bank to force the majority of retail holders to sell to traders who could take up the Equity Option and so ensure that the resolution to insert the call option was passed. As a direct result those who sold have suffered losses and the FSA should investigate the Bank’s actions in this regard.

2. In Respect of Protection of the Rights of Retail Bondholders

Your letter states that this is outside of the FSA’s remit and is something which bondholders must address through the Courts. In view of the issues which have been exposed by the 2009 Lloyds Banking Group Exchange Offer and the recently terminated Bank of Ireland Offer I find this response quite amazing. There are clearly generic areas where the FSA can and should develop rules to provide an appropriate degree of the rights of investors in listed retail bonds. It is clearly not appropriate or realistic to expect individuals to spend hundreds of thousands of pounds to challenge banks in Court especially when banks rack up legal costs at £50,000 a day when challenged. Specific examples are as follows:

A. Despite being aware that its 2009 Exchange Offer would affect over 100,000 retail holders of its bonds and preference shares Lloyds Banking Group (LBG) structured the offer such that the securities offered in exchange for its retail bonds and preference shares could only be held in Euroclear or Clearstream. This would have unfairly excluded many thousands of retail holders who held their old securities Following a vociferous campaign LBG amended the offer such that the new securities could be held in Crest CDI form. This dealt with the problem of Crest holders but many certificated holders were still unable to exchange. Lloyds conceded on those who appointed solicitors to threaten legal action but those who could not were never able to exchange and their subsequent complaints have been ignored. This issue could easily be prevented if the FSA had a listing rule for retail bonds which stipulated that issuers must make every effort to ensure that securities offered in exchange can be held in the same form as those for which they are being exchanged for. And failing that must make an equivalent cash offer to retail holders.

B. Despite being aware that over 90% of the notes were held by over 3,000 small retail investors (about 2,500 in original certificated form) Bank of Ireland structured its offer such that there was a deadline of only a few days for ‘Early Bird’ acceptance and the preferable 40p plus accrued interest Equity Exchange Offer was only open to a small number of holders. In response to another vociferous campaign the Bank first extended the acceptance deadline and then terminated the offer. This could have been avoided if the FSA had listing rules as per (A) above and to require that all holders of the same class of security are treated equally and fairly.

C. Part of the recent Bank of Ireland liability management exercise was an attempt to amend the terms of bonds to insert a call option which would significantly devalue the bonds. Where such resolutions to vary the terms of retail bonds are to be sought it is essential that all holders are able to receive notice of the meeting and resolution and be entitled to vote in person or by proxy. However, many retail bonds are held in Crest and holders do not receive notice of meetings or voting rights as a matter of course. The FSA should, therefore, develop rules and procedures to resolve this problem and ensure that retail holders of listed bonds are able to receive notice of meetings and voting rights.

These are all basic generic issues which have been apparent to the FSA for some time and, on which it should act. Furthermore, the ridiculous situation whereby the fundamental Listing Principles do not apply to issuers of retail bonds should be addressed as a matter of urgency. In the FSA’s letter to myself of 3 February 2010 in respect of the Lloyds Banking Group Exchange Offer Jean Moorhouse stated:

The Listing Rule requirements applying to buy-backs of non-equity securities such as Lloyds preference shares and subordinated debt are quite limited.

And in her letter of 4 March 2010:

Principles 3 to 5 (of the Listing Principles) are specific to equity securities only, as preference shares are not equity securities for the purposes of the Listing Rules, the Listing Principles do not apply.

In fact evidence suggests that the FSA has moved backwards in respect of protection of holders of UK listed retail bonds in taking the view that disputes between retail holders and issuers of retail bonds are a matter for the courts. The terms of many PIBS include a dispute resolution clause whereby the Building Societies Ombudsman (BSO) will arbitrate on matters of dispute. The BSO was succeeded by the FSA / FOS yet both bodies now refuse to provide arbitration when dispute arises. This was demonstrated in the case of the Lloyds Exchange Offer when several holders of former Halifax PIBS asked the FSA / FOS to arbitrate and were refused.

3. Review of Listing Rules for Retail Bonds

You state in your letter that the UKLA has sought to bring greater clarity to the distinction between different segments. However, all it says on the UKLA section of the FSA website is:

The FSA, when it acts as the competent authority under Part VI of FSMA, is referred to as the UK Listing Authority or UKLA. In this role, the FSA is a securities regulator, focused on the companies which issue the securities traded in financial markets.

By making and enforcing the Disclosure and Transparency Rules, the Listing Rules and the Prospectus Rules, we aim to protect investors and foster appropriate standards of transparency, conduct, shareholder rights and due diligence

This hardly explains the FSA’s current limited rules and light touch attitude to regulation of issuers of UK listed retail bonds.

You also state that the FSA the UKLA will seek to ensure its rules continue to be fit for purpose and responsive to market developments. I would point out that a large number of PIBS and former PIBS were issued in the early 1990’s and since than it appears that the FSA has reduced protection and arbitration on behalf of holders of UK listed retail bonds. The 2009 Lloyds Banking Group Exchange Offer, recent Bank of Ireland Offer and the restructuring of West Bromwich Building Society PIBS all exposed issues which the FSA has failed to identify and act upon.

I repeat my demand that the FSA takes immediate steps to restore market confidence and reassure distressed investors in former B&W PIBS by announcing an immediate review of its listing rules and procedures for regulation of issuers of UK listed retail bonds. I would also point out, that in this context, I am not a member of the public but rather the closest there is to a representative body for the interests of investors in retail bonds. I therefore ask to be actively included in this process.

I look forward to hearing from you as a matter of urgency.

Yours sincerely

Mark Taber

Fixedincomeinvestments.org.uk

cc: Mark Hoban – Financial Secretary to the Treasury

John Hale – Association of British Insurers

Gillian Warmsley and Pietro Poletto – London Stock Exchange

Phil Jones – Treasury Select Committee

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Letter from FSA - 14 July 2011:

 https://docs.google.com/viewer?a=v&pid=explorer&chrome=true&srcid=0B8hzbUJuMAkqOWE5NTQ5ZTMtOWIyNy00OWM3LWI2NWUtZTIyNjZjYWQ3M2Zk&hl=en_GB

 

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This is a 'better late than never' article I am afraid. It has been on my to-do list for some time but for some reason I have been putting off writing about the findings of the National Audit Office (NAO). In case you are wondering what the NAO's purpose is I think their vision statement 'to help the nation spend more wisely' will do.

 

On 18 March the NAO published a 41 page report on the subordinated debt buybacks undertaken by Bradford & Bingley and Northern Rock Asset Management. If you would like to read the report you can download it in PDF format from:

 

 

Or you can read the mains points relevant to holders of the subordinated debt based on my reading ! These are as follows:

The providers forecast the build up of substantial taxpayer profit reserves over time. Against this, we estimate the subsidy has a present value of at least £3 billion, assuming the current forecast repayment schedule and interest rates. This subsidy could be substantially reduced by increases in the interest rates (which UK Financial Investments is already exploring) or future balance sheet restructuring.

So we have some good news there in that forecasts of the build up of substantial taxpayer (shareholders) profit reserves means growing buffers to protect subordinated bondholders from losses. But also a bit of bad news in that it seems they are looking at increasing the interest rates on the Government loans which would reduce the build up of profit reserves. I feel this one is a delicate point. Any attempt to increase the rate of interest to above market rates would leave HM Treasury open to claims of abusing its dominant shareholding to procure unfair preference to favour itself as a creditor over external creditors.  The report also reveals the rates currently being paid on the Government loans to be as follows:

Northern Rock Asset Management:

£21.86 billion HM Treasury loan at BoE Base Rate + 0.25%

Bradford & Bingley:

£15.66 billion FSCS Loan - interest free to B&B, cost to FSCS 12 month LIBOR + 0.3%

£2.76 billion HM Treasury loan - interest free

£8.55 billion Working Capital Facility at BoE Base Rate + 1.5%

Clearly, the interest charges will increase in line with interest rates (particularly the B0E base rate) but, against this, interest income should also increase due to the effect on tracker and SVR mortgages. A point which the NAO has missed in its report is that NRAM and B&B will be paying corporation tax on their profits and increasing the interest on Government Loans will reduce the level of profits on which tax is charged.

Next some reassurance that the Treasury is likely to continue to support the solvent rundown as it should produce the best return for taxpayers:

The consequence of the Treasury’s current approach described above is that taxpayers are adopting most of the risk on the mortgage providers’ liabilities. So long as the Treasury follows its current approach of ensuring the providers wind-down in an orderly fashion effectively, the other creditors, including the subordinated debt-holders, should not lose any of their investment during the orderly wind-down. Treasury is likely to follow this approach so long as it believes that an orderly wind-down would generate the best return for taxpayers.

Although against that we are told:

Following the current approach, it could take the mortgage providers over 15 years to repay the taxpayer support.

In respect of the remaining subordinated bonds:

The remaining subordinated debt represents a cost for little benefit to taxpayers. UK Financial Investments should continue to explore ways of eliminating the remaining subordinated debt. In doing so, Treasury should come to a view on whether it believes that further payments to the subordinated debt-holders represent a moral hazard – creating expectations amongst debt-holders that reduce their incentives to avoid risk – and whether there are other ways of eliminating the subordinated debt.

Although the debt continues to accumulate suspended interest into a sum to be paid once the providers had returned all the taxpayer support, the terms of the debt do not allow interest on the interest (it is non-compound). Consequently the value of the debt and its interest falls with inflation and the money value of time.

The NAO have got their facts wrong in this last paragraph. All the B&B LT2 bonds which had their terms changed on nationalisation now have interest on interest at the respective coupon rate for each issue and the 8.399% NRAM RCI's have interest on interest at 10.399%. It is pretty shoddy that the NAO failed to get this right in researching their report especially as they use their incorrect assertion that there is no interest on interest to summise that the real value of deferred interest is falling over time. When, in fact, it is accruing interest at a rate well above the rate of inflation ! Had they picked up on this point it should have strengthened their recommendation that these issues be 'eliminated'.

A final point from the report which made me chuckle is:

UK Financial Investments did not fully document how it came to its final decision to price the first tender offers. Although it argued it is common market practice for clients to make final decisions in an unminuted conference call with the banks and advisors, UK Financial Investments faces intense public interest and needs to uphold rigorous standards of public administration. It has agreed to document all its key decisions in future.

Perhaps I now know why they have tried so hard not to reveal any information in response to Freedom of Information Act requests !

Overall I take the report to be broadly positive for holders of NRAM and B&B subordinated debt although I have written to the head of the NAO to point out its error concerning interest on interest.

As always I am interested in the views and comments of others. Please email me at mark@fixedincomeinvestments.org.uk to let me know what you think.

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Following on from the Subordinated Liability Order ( see Noonan's Seismic SLO) AIB have delivered a further shock to the market in the form of the most aggressively coercive 'tender offer' yet seen. While most were expecting an offer to follow on from the SLO the form of the tender announced on Friday 13 May has left many market participants open-mouthed. Not only is the quantum of the 'offer' pitched below the level dealt to Anglo Irish bondholders but it also breaks new ground in that no payment will be made in relation to accrued interest. This is particularly harsh on holders of AIB 12.5% 2019 Euro and Sterling Notes as they pay annually on 25 June so the bank is seeking to welch on nearly a year of interest ! In order to 'persuade' noteholders to take the medicine a triple stick approach has been used as follows:

 

1.    The Subordinated Liabilities Order - this proposes to extend maturity, make coupon discretionary and non-cumulative and remove dividend stoppers so as to effectively place subordinated debt below ordinary shres in the capital hierarchy. Many expected this to be 'the stick' but, perhaps due to legal challenges by two US hedge funds delaying implementation of the SLO, two new weapons have been whittled;

 

 

 

 

 

 

 

Last Thursday the Irish Finance Minister,  Michael Noonan, delivered a seismic shock to AIB junior bondholders in the form of a Subordinated Liabilities Order under the Irish Credit Institutions (Stabilisation) Bill 2010. While it was widely expected that the Minister would use the powers under the act to vary the terms of AIB junior bonds the extent to which he is attempting to do so is quite staggering. It is, therefore, remarkable how little financial media coverage there has been of events. So I feel compelled to try to generate some interest in what is going on.