Senior debt said "safest play" on Northern Rock

LONDON (Reuters) - Senior bonds of Northern Rock NRK.L are the safest bet for investors as speculation swirls about the fate of the mortgage lender, with holders of lower-ranking debt facing possible losses, analysts said.

The possibilities range from the sale of the lender to another bank -- likely to be the most favourable option for all bondholders -- to a run-off or sale to financial investors, which may bear more risk for subordinated debt.

“Senior debt is the only safe way to play the Northern Rock game as there are three chances of getting your money back: government, takeover or a proportional (maybe 100 percent) recovery in a wind up,” said RBS credit analysts in a note.

Short-dated issues offer the best chance for investors to take advantage of the government guarantee on Northern Rock bonds, while longer-dated debt has the largest discount to par and therefore is likely to rally harder on a takeover.

“Sub debt remains a high risk and a pretty much binary trade -- great upside if taken over in full but a deeper downside in a wind up,” RBS said.

Credit rating agencies are at odds over the bank’s outlook, with Standard & Poor’s cutting Northern Rock’s subordinated debt to “junk” status, while Moody’s Investors Service and Fitch Ratings have kept it in investment grade.

Fitch analysts said on a conference call on Monday Northern Rock faced a liquidity issue, not a solvency problem, and that senior creditors should rank equally in the event of liquidation or a takeover.

Other classes of debt holders, such as subordinated or tier I bondholders, cannot rest so easy.

“You only get in that situation if you see a liquidation or a distressed sale in a restructuring,” said Ian Linnell, head of EMEA financial institutions at Fitch. He said that could involve a range of creditors who rank ahead of subordinated debt holders come to the negotiating table with claims.

“But our expectation is that we’re very, very far away from that scenario.”


Fitch said the recent one-notch downgrade of Northern Rock’s hybrid bonds -- a blend of debt and equity -- to BBB was not more aggressive, based on the premise that there is no capital or asset quality problem.

“There is no reason why the bank would have to start deferring on its coupons,” said Gordon Scott, a managing director at the agency.

The government has offered a guarantee to senior debt with a caveat attached that it will last for the duration of the current market instability. That guarantee excludes subordinated debt, covered bonds and asset-backed securities, making those a less attractive asset for holders.

Analysts say the chances of an industry competitor emerging as a buyer for Northern Rock are fading. Lloyds TSB LLOY.L has already considered a deal but damage to the Northern Rock brand means a break-up of the bank now appears more likely.

A bid by a private equity firm seems unlikely given the scarcity and higher costs of funding, related to the financial crisis which has spiralled from initial problems in the U.S. subprime mortgage market.

Speculation is building about potential bidders and the Sunday Telegraph reported three leading hedge funds are planning a break-up bid.

Such a bid would be less advantageous for bondholders, analysts at research firm CreditSights said. An orderly wind-down, with assets and liabilities run off as they mature, should be relatively painless, however, given Northern Rock’s “good quality assets and strong solvency”, they said.

“A large part of the mortgage book should take care of itself in a wind-down,” according to CreditSights, with 74 percent of the residential mortgage book and 63 percent of the total loan book funded either by asset-backed securities -- funded through the Granite programme -- or by covered bonds.