10 September 2010, Financial Times Fund Management

Most investors wouldn’t touch a stock that has stopped paying a dividend. And when a preferred stock dividend is suspended, the security has lost its raison d’être. But there is the exception.

Royal Bank of Scotland–which became 85 percent state owned as a result of how poorly prepared it was to deal with the global banking crisis–suspended payment this past spring on seven US-dollar denominated preferred series that trade on the New York Stock Exchange. This sliced their original $25 par value–the price at which these shares were originally issued with coupons north of six percent–in half.

But unlike most other distressed preferreds, there is a fair chance that after 18 months these dividends may be reinstated. If this happens, then their share prices should move up sharply, generating an annualized return in excess of 20 percent, according to Brian Gonick, principal and director of the $250 million hedge fund Senvest Partners.

Senvest has been buying RBS preferreds since they bottomed in early 2009 at the depth of the financial crisis. The fund took quick profits as the bank stabilized and then offered to buyback preferred shares substantially above Senvest’s costs.

This isn’t an outlier for Senvest. The fund’s track record for making contrarian bets has been impressive. The New York-based fund is up 32 percent net over the past year through August, and 20 percent net annually since its inception in April 1997.

The logic behind the current play is based on the fact that dividend suspension was ordered by the European Commission’s Competition Committee, who decided the bank was enjoying an unfair financing advantage due to the large government stake in the company. And it demanded that for two years most preferred investors share the financial burden that the UK government had taken on.

“But for this ruling,” says Gonick, “RBS would most likely have continued paying on all of its preferreds because, one, it has the resources to do so, and two, not paying would have sent a message to capital markets that would’ve been far more damaging to the bank’s operations.”

Gonick’s projected return is based on analysis of two RBS preferreds, both with coupons of 7.25 percent: the Series H, which is still paying dividends, and the Series T, which is not.

In early September, the “H”s were trading at $21.76 and yielding 8.3 percent. The non-dividend paying “T”s were trading at $15.19. Both preferreds don’t mature, they don’t make up missed dividends, and their yields shadow long-term rates. Currently, the “H”s are paying nearly 200 basis points more than “A-”-rated bank preferreds.

Gonick makes several basic assumptions: suspension on RBS dividend payments will be lifted in 18 months, the spread between RBS and benchmark preferred yields will remain close to where they are today, and long-rates will not significantly move.

Based on a target yield of 8.5 percent, this would suggest that the RBS preferred “T”s would be trading at $21.33 once its dividend is reinstated. This represents an annualized gain of nearly 23 percent.

UBS Wealth Management Research fixed-income strategist, Barry McAlinden, thinks Gonick’s assumptions are reasonable. But he urges continued due diligence. For instance, he would want to see RBS continue to show profitability driven by its core businesses. And he would monitor the UK government’s stance towards the bank. It could demand further burden sharing by preferred investors, especially if it maintains a substantial financial interest in the bank for a longer period than expected.

“While it’s unlikely that the European Commission would extend the moratorium on dividend payments,” says McAlinden, “it’s certainly not out of the question because we are in uncharted regulatory territory and there is still a great deal of uncertainty ahead.”

Eric Chadwick, co-portfolio manager of US-based Flaherty & Crumrine, who manages $4 billion in preferred securities, understands the potential of investing in the non-paying RBS shares. But as a credit-focused firm, he would not buy the bank. “Its “C” corporate rating by Standard & Poors is below our clients’ minimum standards,” says Chadwick, “so we couldn’t buy the suspended preferreds even if we found the investment compelling.” He believes the bank, while getting healthier, still carries considerable risk.

While agreeing uncertainty surrounds the preferreds, Gonick believes that he’s simply getting in front of an improving situation. “The UK government saved the bank during the worst financial crisis we’ve seen since the Depression,” says Gonick. “So it’s hard to conceive a scenario wherein it will give up on RBS. That means taking care of important sources of financing, including preferred shareholders because RBS relied on preferred capital more than any other bank.”

Gonick also observes that the bank is effectively selling off assets at reasonable prices and repairing its balance sheet. While not thriving, the UK economy is doing better than expected, and it appears that current growth will keep the global economy from falling back into recession. All of this bodes well for RBS, leading Gonick to believe that these preferreds offer one of the best risk-reward opportunities today.

If he’s right, then investors should also keep their eyes on another series of RBS preferreds, whose dividends will be suspended starting next spring. According to UBS’ McAlinden, the bank’s acquisition of ABN Amro included three of the Dutch bank’s preferred shares: series “E”, “I”, and “G”. They have been rebranded as RBS Capital Funding Trusts V, VI, and VII. The deal required RBS to maintain dividend payment on these preferreds for at least one year after their legal conversion. But the European Commission has ruled that starting in April 2011, their dividends can’t be paid for two years.

“Despite offering three more quarters of dividends,” observes McAlinden, “these preferreds are now trading at nearly suspended-level prices.” This means that investors will not only receive attractive income through next winter, but they may also benefit from rising share prices as the dividend moratorium comes to an end in spring 2013.