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Co-Op Bonds Update

Monday, June 17, 2013
Mark Holman

It is well known that the Cooperative Bank has been in extensive talks with the UK Regulator regarding its capital base. Management announced this morning that they aim to raise an additional £1.5bn in Core Tier 1 Capital, which is significantly higher than previous expectations, but is an amount which will transform the Bank and return its focus to its core retail business. The magnitude of the capital raising draws upon significant support from the parent group as well participation from subordinated bond  holders (so-called Target Security Holders) who will be asked to contribute towards the recapitalisation through an exchange issue, but will be in a position to share in the future upside of the Bank’s transformation.

The restructuring plans are intended to result in the transformed bank obtaining a fully loaded Core Tier 1 ratio of in excess of 9% by the end of 2013. Shares, issued as part of the restructuring (targeted for October 2013), will be listed on the London Stock Exchange.

The bank expects that at least £1bn of the capital will be generated in 2013 from the exchange offer and that the other £500mm will come in in 2014, primarily through disposals of businesses such as asset management and insurance businesses owned by the group.

As far as fixed income investors are concerned the main concerns will be for the subordinated debt holders of the Co-op Bank Debt.

There are 10 Target Securities that are to be affected by the tender:

Lower Tier 2: Total £937mm
Coop FRN 2016
Coop 5.875% 2019
Coop 9.25% 2021
Coop 5.625% 2021
Coop 7.875% 2022
Coop 5.75% 2024
Coop 5.875% 2033

Upper Tier 2: Total £310mm
Coop 5.5555% Perpetual
Coop 13% Perpetual

Tier 1: Total 60mm
Coop 9.25% Perpetual

The exact terms of the tender will not be known until October 2013 according to the Group.

However, they have stated that different exchange terms would apply according to the different tiers of bond holders. They also announced that the coupons on the 13% Upper Tier 2’s will be suspended until the exchange and that future coupons on the other discretionary instruments (i.e. the Perps) would be decided in accordance with the regulator. Holders of the 5.5555% should be happy about the timing here as they received their coupon last week (14th June).

Today’s announcement specifies that holders of targeted securities will be invited to exchange their bonds into a combination of:

1. A new senior unsecured instrument of the Group, and potentially a fixed income instrument issued by the bank; and
2. Ordinary shares from an IPO, of which the target bondholders would have a “significant minority stake”

The ratio of these is not yet determined, but the announcement did state that the more junior target bondholders would likely be offered a “substantially greater” portion of bank shares relative to the Group Instrument, and that the more senior target bondholders would be offered “the substantial” proportion in the new Group senior unsecured instrument. The more senior holders in this case are the Lower Tier 2 bond holders.

The company also specified that they recognised the significance of retail investors in its bonds and would be considering a number of alternative options for small retail investors ahead of the exchange offer.

With the key details of the proposals yet to be clarified it is hard to give an accurate assessment of fair value, and much will depend in the short-term on what investors consider to be the monetary amount of the word “substantial”. Moving from subordinated Co-op Bank debt to senior debt issued by the group is clearly a positive, but the equity portion is the unknown. However, for any haircut that bondholders have to take, the additional transfer into equity does give them the chance to earn their discount back in a refocused and newly listed banking group which is well capitalised.

The ability of the bank to turn off discretionary coupons does give the Group leverage over the holders of the most junior debt, and hence they use the word “substantial” for the equity portion. However, the reverse is true for the Lower Tier 2 holders and the Bank will need to make the exchange relatively attractive to ensure meaningful bond-holder support.

So what next?

While all this new information is being digested we expect bonds to trade on wide bid-offer spreads and only in small volumes. No doubt many of the large investment banks will be producing detailed analysis and presenting the market with various valuation scenarios. As we see it, a considerable amount hinges on the word substantial and also in the fact that an exchange remains voluntary and hence to be successful there has to be a degree of synergy. Our view internally is that substantial means at least 80%; which would infer a return for LT2 holders of between 80% and par, plus an equity stake,  but we would stress this is very much an intuitive feeling and not based on any precedent or detailed analysis.

While the medium-term outlook for the Co-op Bank (post exchange) may well be a safer better-capitalised institution with a strong retail and SME focus; the plan does obviously carry a reasonable degree of execution risk. In the short term we would expect to see another ratings downgrade, possibly to the lower-end of CCC, as bond holders are being prepared for possible haircut.

The next 3-4 months in the run-up to the exchange will be an uncertain period but the Co-op need to make the exchange attractive enough to make LT2 bond holders participate. Therefore at current levels it may well be worthwhile holding one’s nerve and positions in the lower Tier 2s, but for the most junior bonds the outlook could be very different and investors may have to take a very long term view as shareholders in the group.

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