Back in April 2011, in Dixons in the dock, we suggested the different views that bondholders and shareholders had on the electrical retailer’s prospects pointed to a window of opportunity for value investors. A similar point could now be made about the UK’s high street banks.
During the credit crisis, any bank that wanted to secure funding from investors was forced to issue its bonds at unusually high coupon rates. So in March 2009, for example, Lloyds issued a 10-year bond that paid a 15% coupon – and then saw the bond’s price collapse shortly afterwards as the market convinces itself one or more of the UK’s banks would go bust.
At the time we felt this was an amazing opportunity for investors because, while it was now trading on equity-like valuations, the risk for bondholders was much reduced and the debt was paying a huge coupon. As a result, investors could make significant returns while, as bondholders, being much higher up the creditor pecking order (in other words, in the event the bank was wiped out) they were still likely to receive something back.
The 2009 Lloyds instrument was by no means alone here and, as the years have passed, bank bonds have continued to trade in an aggressive manner because of what has happened in the financial sector. What is interesting, however, is with all the good news of the last few months – manageable capital rules, a better outlook and so on – bank bond prices are at their highest levels since the credit crisis.
To put it another way, the debt market – which, remember, is mainly focused on identifying and appraising a company’s safety – thinks bank bonds are as safe or as attractive as they have been in four years, yet bank equity values are nowhere near the highest prices they have been in that time.
We are not suggesting bond and equity holders take the same level of risk – even if some types of bonds do have equity-like qualities – but we would argue many of the issues still worrying equity investors, such as capital rules and insolvency, are the same ones on which debt holders are most acutely focused.
Yet bank equity is now valued much more cheaply than any form of bank debt and such a state of affairs – as we saw with Dixons and indeed with house builder Taylor Wimpey – can foreshadow good news for equities.
Not that bondholders will always be right and equity holders always wrong, but what we do know is that they are both currently focused on the same question here – are banks going bust? And when one camp seems to be taking quite a different view from the other, investors would do well to take note and take a closer look themselves.