Discover's lowest-rated fin'l deal has highest yield of 2012

By Danielle Robinson

NEW YORK, Oct 12 (IFR) - Institutional and retail bond investors pounced on Discover Financial's preferred offering this week for its 6.5% yield, shrugging off its single B+ rating from Moody's and Fitch and their own exposure to maturity extension risk if Treasury rates rise.

Discover sold $500 million of perpetual non-call five-year preferreds, via Bank of America Merrill Lynch, Citigroup, JP Morgan, UBS and Wells Fargo Securities. It was the lowest-rated financial issue of the year so far and the highest yielding.

More than $850 million of institutional orders poured into the book; ultimately 60% was sold to individual retail investors and the rest to portfolio managers of mostly private banking money. Demand held up despite warnings from some analysts against such fixed-for-life structures as the risk of rates rising in the next five years is high.

Retail and institutional bond investors are tapped by issuers of preferreds because it's usually implicit in the structuring of the deal that it will be in the issuer's best interest to call the notes at their call date, usually set at five or 10 years.

However, with rates so low, there's a strong chance that deals without any floating rate step-up coupon at the call date will not be called if interest rates rise and make it more expensive for the bank to replace the deal with another capital security.

"We recommend selling low-coupon fixed-coupon fixed-for-life preferreds outright or swapping into the fixed-to-float securities," said Barclays credit strategist Shobhit Gupta in a recent report on the preferred market.

If 30-year yields rise to 4%, the price of JP Morgan's US$1.1bn 5.5% US$25 par perpetual non-call five preferreds issued in August could drop 10 points, because at that point they would be more expensive for JP Morgan to call and replace with higher yielding perpetuals, according to Gupta.

The more sophisticated institutional investor base is presumably aware of the extension risk of fixed-for-life perpetuals. But they could be thinking they can sell the securities at the first whiff of a rising rate environment to retail investors, who have historically been much slower to pick up on market trends.

Some institutional investors are also hedging against the interest rate risk inherent in the fixed-for-life perpetuals.

Most institutional and retail investors, moreover, have little choice but to buy whatever comes into the preferred market these days.

"There was something like US$26-US$28bn of Trust Preferred Securities taken out of the preferred market by banks in the summer, which has left holders of these securities like ETFs and other funds with a pile of money they have to reinvest," said one banker.

"Those TruPS had much higher coupons than what you can get today, so there is a strong market for the new fixed-for-life deals, especially when they offer a nice coupon."

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(Reporting by Danielle Robinson; Editing by Ciara Linnane)

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