RBS Has Cold Cash Under Its Kilt

05/04/2011 1:02 pm EST

Focus: GLOBAL

Paul Tracy

Editor, The StreetAuthority Market Advisor

The once-troubled bank’s NYSE-traded preferred shares yield almost 8% with limited risk, writes Paul Tracy in High-Yield International.

The Royal Bank of Scotland (RBS) was hit hard during the financial crisis, but its financial position and profitability have improved dramatically over the past two years. Offering an attractive 7.7% yield, RBS preferred Series F (RBS-PF) is a solid buy with moderate risk

Between 2000 and 2007, quick growth for RBS came primarily through a series of acquisitions. The bank's 2000 acquisition of UK banking giant NatWest was considered a bold move at the time, since NatWest was the far larger institution.

However, that deal gave RBS a solid branch network, and access to low-cost capital in the form of retail banking deposits. Deposits are an attractive form of funding, because banks pay extremely low rates of interest to depositors.

But not all of the bank's deals were opportune. RBS was part of a consortium that bid aggressively for Netherlands-based ABN Amro in late 2007. The expensive deal gave RBS an attractive operation in fast-growing Asia, but the timing was poor, depleting RBS's capital just before the global recession and financial crisis.

Like most banks in the developed world, RBS also suffered from its exposure to mortgage bonds and other toxic assets. Even worse, RBS depended on interbank funding, a market that completely dried up amid the crisis.

The UK government stepped in to bail out RBS by injecting capital into the institution and insuring the bank's most troubled assets. In exchange for the support, the UK took an 84% stake in the firm and prohibited RBS from paying dividends for a period of at least two years.

European Union competition authorities subsequently demanded RBS make even more concessions in exchange for the government support, including the sale of its insurance business, some UK branches, and other non-core assets. The EU also demanded that RBS stop making dividend payments on certain series of preferred shares for at least two years, starting in April 2010.

Almost Back to Normal
But RBS has recovered significantly over the past two years. At the height of the crisis, its Tier 1 capital ratio—a measure of a bank's financial adequacy—was around 4%, but that ratio had nearly tripled to 10.7% by the end of 2010.

In addition, the bank's loan-to-deposit ratio—a measure of RBS's outstanding loans compared to its low-cost deposits—fell from more than 154% in 2008 to just 117% at the end of last year, not far from the bank's 100% target level.

In the bank's most recent conference call, management noted that it is preparing for the UK government to make an orderly disposal of its 84% economic stake. And by the end of 2012, RBS plans to exit the government's toxic asset insurance scheme, a sign of rising confidence.

Thanks to improving profitability and a stronger capital position, RBS also plans to resume dividend payments on its common stock.

RBS's Series F Preferred shares are traded on the NYSE and denominated in US dollars. The shares pay a quarterly dividend of $0.478125 per quarter, equivalent to a yield of 7.7% at Wednesday’s intraday price of $24.75.

Because the Series F was issued long before the financial crisis, RBS was not required by EU competition authorities to suspend payments on these shares, and has continued to make its quarterly distributions in full and on time.

The series F preferred can be called at their par value of $25 at any time. That's a slight premium to the current price, so such a move would not hurt today’s buyers.

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