Scottish income: Royal preferreds

In her top-ranked Global Investing advisory, Vivian Lewis looks at a lesser-known area of the income market -- non-cumulative preferreds -- explaining these vehicles and offering some favorites.

"Over 20 years ago, Barclays Bank, which is British, invented a new vehicle for raising money in the U.S. market to enhance its capital ratios and finance its growing dollar business. 

"They were called non-cumulative preferred shares and were issued at $25/share to pay dividends four times a year just as normal U.S. stocks do. The clear target for these vehicles was U.S. retail investors.

"Some British banks use a different term, non-cumulative preference shares; they mean the same thing.

"At the time, Barclays was able to enhance the amount it was paying in dividends by using a feature of the British tax code called Advance Corporate Taxes. This no longer applies. 

"So the yield on preferred shares now is actually being paid as a cost of capital by the British bank. And the price of these preferred shares is now much less than $25 because banks are in crisis.

"Non-cumulative (usually abbreviated nc) means that if a payment has been omitted (because the bank lacks the money to pay) it will not be made up. It is important to note that nc does not mean non-callable as some investors and even some brokers seem to think. 

"Being non-cumulative increases the risk of these preferred shares. The reason for this feature was to be able to treat the proceeds of these issues as part of the formal capital of the issuing banks under international regulations.

"The rules are based on ratios of equity capital to lending and the preferreds count as equity precisely because they do not always have to pay back.

"Barclays quickly was copied first by other British banks with the same tax code, and then by banks in Ireland and Australia which had similar advance corporate tax rules. 

"But soon the rest of the world caught on and preferred shares were issued by banks from Greece to Spain, from the Netherlands to Switzerland, from Germany to the U.S.A.

"And investment banks and mortgage guarantors (like FNMA) as well as industrial corporations and utilities also issue preferreds.

"But among foreign issuers, the British banks are leaders in tapping this market and their paper has the largest volumes of trading. I currently own and recommend three series of British bank non-cumulative preferred shares, all issued directly or indirectly by Royal Bank of Scotland. 

"Royal Bank of Scotland (RBS) is the Citicorp of Britain. RBS bought ABN-AmRo, a Dutch bank, right before the global financial crisis hit, and its survival was in doubt until the government bailed it out. It is essentially controlled by the U.K. version of TARP. That adds to risk and payout. 

"Now about risk. RBS went on a world shopping spree, which involved more than ABN and NatWest.

"Its management has been deposed by shareholders, who are fiercer than those who own C in the U.S. And its payout policy is set by the British Chancellor of the Exchequer (their Treasury Secretary) because the government is the largest shareholder.

"If RBS were to omit a dividend payment, as it can do under the non-cumulative rules, this would create panic in the high-volume U.S. market for these entities.

"Any one omission of payment would zap the whole sector, and not just RBS preferreds. Then RBS and other banks could buy back the preferreds cheaply and get this costly stuff off their books.

"In my view, this is unlikely. First of all the reputational risk would be considerable. Banks like to pretend they are good citizens with safe accounts, whatever the truth is. There could be a run on the bank by Scots and other Britons removing their deposits.

"Then, too, banks are desperately trying to enhance their capitalization ratios, which is why non-cumulative preferreds were invented in the first place. 

"Finally, I think the British Treasury does not want to cause an international incident by hurting U.S. retail investors. If even the worst bank were to skip a dividend, it would hurt the whole City of London.

"You can buy different preferred from RBS: there are a dozen different issues, a veritable alphabet soup. The RBS issues I own and follow are the preferred F which yields 13.8%; the preferred P which yields 13.6%, and the National Westminster preferred C which yields 14.8%.

"Overall, these three issues happened to be the cheapest and highest yielding when I was shopping for RBS preferreds."