Questor: bank shares have been terrible for income investors – so buy their bonds instead 

Questor share tip: dividends have dried up and share prices have halved. Bondholders are the ones to benefit from banks’ newfound strength

Barclays' third-quarter results were described by one investor as 'a timely reminder of how robust the major banks have proven to be this year' Credit: Stefan Wermuth/REUTERS

Banks are far stronger and more stable now, despite the pandemic and the economic damage it is doing, than they were during the global financial crisis. But are shareholders benefiting?

They certainly aren’t if they invested for income. Regulators told the banks not to pay any dividends when the pandemic struck on the basis that they should conserve all the cash they could so that they could lend more and support the economy.

This has in turn hardly helped bank share prices, which are at not much better than half their pre-virus levels.

So shareholders’ reward for providing capital to Britain’s now bombproof lenders is to be forcibly deprived of all their income and subjected to the loss of half of their wealth.

But certain other investors in banks are faring better. In fact, some of the pain borne by shareholders has directly benefited these other investors, and they are also the much more direct beneficiaries of the banks’ financial strength. These other investors are of course the banks’ bondholders.

Bondholders care only that the business remains a going concern able to meet its obligations to them.

Hence anything the business does to conserve cash – such as suspending dividends – or to make itself stronger – such as following regulators’ stricter rules on reserves after the financial crisis – is good for bondholders, despite the share price pain for investors.

The point was made last week by TwentyFour Asset Management, a bond specialist, when it commented on the release of third quarter results from Barclays. It called the results “solid” and “a timely reminder of how robust the major banks have proven to be this year and how well they have managed their way through the current crisis”.

It added that, “despite the obvious headwinds of the pandemic and its related economic uncertainty”, Barclays had increased its key capital reserves ratio by more than 8pc from 13.5pc at the start of the year to 14.6pc at the end of September. It said this, on top of the setting aside of almost £3bn to cover losses, “should give bondholders a degree of comfort”.

It also speculated that even though Barclays’ chief executive, Jes Staley, had said the bank would speak to the Bank of England later in the year about dividends, “we would still expect the regulator to keep some control on the level of distributions in order to maintain healthy capital ratios”.

“In our view results such as these highlight potential opportunities for fixed-income investors, given that they illustrate how a bank with a diverse set of revenue streams, such as Barclays, can continue to maintain healthy capital buffers to protect payment of bond coupons [interest],” TwentyFour said.

Its conclusion: “We believe bank equity remains highly cyclical, but post-2008 bank debt has been less so, and consequently should be a lot more stable for investors.” If we look at things from the perspective of an income investor, this is unarguable.

In short, bank bonds are a better bet than bank shares. We have already advised readers to sell shares in Barclays itself and, in our Income Portfolio format, Lloyds. Our rating on HSBC and NatWest, as RBS is now known, is hold.

We would not advise selling the latter two now after all the damage has been done but new money should go into bank bonds, not shares.

Which ones exactly? Bank bonds come in many forms, some of which are not available to private savers.

Many of those that are, said Gary Kirk of TwentyFour, are “legacy” bonds issued before changes to the rules concerning what counted as capital. The legacy bonds tend to yield more but will become less useful to banks at the end of next year.

As a result, banks are likely to redeem them if the bonds’ terms allow it or make an offer to investors to buy them back, Mr Kirk said, although shareholders could refuse.

A more straightforward option would be the Halifax bonds that we chose for the Questor’s Income Portfolio in May. They are perpetual and there is nothing in the terms to allow the borrower, now Lloyds Banking Group, to force early redemption.

Should Lloyds decide to suspend interest payments – which we regard as very unlikely – it would have to make up the missed amounts later. The bonds currently yield 5.9pc. Lloyds’ shares, of course, yield zero.

Questor says: buy

Ticker: HALP

Share price at close: £160.25

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