The bewitching appeal of Lloyds suspended preference shares

Update 3/5/2012: Brokers are now listing LLPC as due to resume payments of coupons on 31 May. Looks like the gamble has paid off. With luck, 10%+ yield locked in for perpetuity, notwithstanding another banking crash. 🙂

Important: What follows is not a recommendation to buy or sell shares. I’m just a private investor, storing and sharing notes. Read my disclaimer.

Previously I’ve written about my purchase of Natwest preference shares. I’ve now added some Lloyds TSB 9.25% Non-Cumulative Irredeemable Preference Shares to my portfolio, too.

These Lloyds preference shares – which I’ll sometimes call by their stock ticker, LLPC, below, because Lloyds TSB 9.25% Non-Cumulative Irredeemable Preference Shares isn’t the catchiest name you ever heard – are a trickier proposition than the Natwest preference shares.

For a start, LLPC shares are not currently paying an income, and almost certainly won’t for two years.

More on that in a minute. First, some details:

Lloyds 9.25% Preference Shares

Ticker: LLPC
To buy: 83.5p
Coupon: 9.25%
Running yield: 11.1% (Suspended)
Payments: Twice yearly (31/5, 30/11)
Other details: Non-cumulative, non-mandatory
LLPC summary on Digital Look

Other features of the LLPC preference shares

• Perpetual: That 9.25% coupon is payable forever (when it’s paid!)

• Non-cumulative: Investors don’t get recompense for skipped coupons.

• Non-mandatory: Because they’re discretionary, the EU has forced Lloyds to show discretion – and blocked the coupon!

• As I understand it, payment of a dividend to ordinary shareholders is not permitted unless the coupon on these preference shares is paid, too.

Please also read my introductory article on preference shares if you need to.

No income expected until 2012

Back to that snag – there’s an apparent 11.1% running yield on the prefs, but you’ll have to wait for it.

The UK government aid given to Lloyds Banking Group at the time of the banking bailout was deemed by the EU to constitute state aid. As part of the subsequent legal wrangling, it was agreed that Lloyds would not pay coupons on its non-mandatory tier 1 and upper tier 2 securities for a period of two years, starting January 31st 2010.

These LLPC Lloyds preference shares fall into that category, and so their coupon was blocked. The first payment that holders of LLPC can be pretty confident of receiving will arrive in May 2012.

A further significant point is that Lloyds cannot pay a dividend to ordinary Lloyds shareholders without also paying LLPC holders.

Could they pay out before 2012?

Some private investors have been trying to outwit the Lloyds legal department and prove that it didn’t have to suspend payments of LLPC and certain other Lloyds preference shares – or even that it legally shouldn’t have.

It’s a very fiddly debate, involving tens of thousands of words exchanged. So far Lloyds has won the day. I don’t pretend to understand the intricacies, but I’ve had some insight into how these big banks operate from a legal perspective, and unfortunately I don’t think the investors will win.

Separately, some analysts suggest Lloyds may want to resume paying ordinary dividends before 2012. The Lloyds dividend was sacrosanct for 200 years, and the board will be keen to restart a payout as soon as possible.

These observers feel there may be a way to fudge the EU ruling on Lloyds – by fiddling with its capital position or some other ruse – in order to lift the block on the preference shares coupon, and thus the effective block on ordinary dividends.

It is really more about political wrangling than law. The nutshell theory is that as EU regulations can be made on a whim, presumably some ‘fix’ can be agreed with Brussels on-the-fly, too.

I don’t think it’s very likely, but it’s an opinion in the market.

Yet more bad news: the 11.1% yield isn’t really 11.1%

If you’re wondering why I bought these shares, you should know it isn’t for the 11.1% yield – because the effective yield is smaller.

It’s true that if you take the 9.25% coupon and the bid price of 83.5p, and work out the running yield, it comes to 11.1%.

But remember, we’re not seeing payments for two years! And due to the time value of money, buying LLPC today means paying a price for waiting.

There’s a complicated way to work this out, and a down-and-dirty way that amounts to the same thing.

Here’s the dirty way:

Buying LLPC shares today means forgoing 18.5p in income.

This effectively means the price of the shares is 83.5p+18.5p = 102p.

The running yield on a bid price of 102p is then (9.25/102) = 9%

It’s no coincidence that’s the same running yield as on the Natwest preference shares. In fact, it may even suggest LLPC are over-priced, since the Natwest issue looks more secure, and is mandatory and cumulative.

Why I bought the LLPC preference shares

At this point you might be wondering if I’ve lost my marbles? These are income shares that don’t pay an income, that aren’t as attractive as an equally (ill)-liquid issue from Natwest, and which will continue to be dogged by banking wobbles.

However there are several reasons to expect a bit more reward from LLPC in return for some of the risks:

1. Capital appreciation when EU block lifts

In 2012, LLPC will hopefully be paying its coupon again and the unprecedented block will be a thing of the past. At this stage it will yield similar to other bank preference shares, such as NWBD, with perhaps a spread of 0.5% or so to allow for its less attractive status. This means the 18.5p I’m forgoing as income now I expect to make as a capital gain by 2012.

2. Capital appreciation of all fancy bank debt

As someone who is fairly bullish on the economy I don’t expect other bank prefs such as NWBD to be yielding 9% in two years time, either. If LLPC were to yield 7% (with ten-year gilts at say 5%) then perhaps 130p per share is a reasonable target. That’s potential upside of 50% over the next couple of years.

3. Lloyds’ near-term outlook looking rosier

Briefly, the Basel 3 announcement this week suggests the new regulations of banks will be less onerous than feared (or warranted, for that matter). Lloyds is tipped by analysts as one of the banks best-positioned to benefit, as it will be able to count its stake in various other business towards its capital requirements. Less onerous capital strictures means more profit for banks, which means better rewards for investors.

4. You never know

Perhaps there will be a fudge that sees the coupon payments restarted before 2012. Two years is a long time in the markets these days.

A portfolio play

Regular readers may recall I recently bought back into Lloyds ordinary shares. So I’ve increased my exposure to Lloyds bank with these LLPC shares.

While superficially weirder, the LLPC shares are much safer than the ordinary shares – so buying these is less risky than loading up on more LLOY stock.

It also diversifies me away from my Natwest preference shares.

Please be aware these LLPC preference shares are riskier than the Natwest preference shares. And it goes without saying they’re far riskier than a savings account or gilts. My exposure to bank preference shares and to Lloyds ordinary shares accordingly only totals about 5% of my portfolio.

There’s a very real risk of losing all your money if you buy LLPC shares, as with any share. A high yield and potential capital gain doesn’t come catch-free.

That said, I’m coming to these instruments late and after the life-changing gains have already been made by braver punters. I think the risk of these bank preference shares being wiped out was reasonable 18 months ago; now the risk is much lower but so are the potential rewards.

Note: New or sensible investors shouldn’t bother with any of this stuff. Buy a tracker or a simple and cheap ETF portfolio instead.