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Bond of the Week: 12 July 2013

Nationwide 7.25% PIBS.

    

Until May, bonds offered investor stability, strength, and a sense of the permanence about the bull market. No longer. The roller-coaster ride over the past few weeks had thrown the bond bulls off-guard, and make investors aware that bonds are just assets. It will have its ups and down.

As the Fed stepped up its rhetoric about a potential tapering of the QE, bond yields surged across most maturities. This impacted the corporate bond market significantly as spreads relative to government bonds widened. Both Investment Grade and High Yields bonds suffered.

In the UK, another sector was also hit – PIBS, also known as Permanent Interest Bearing Securities. This class of bonds is issued by building societies because these institutions are unable to tap into equity finance. (This subject was last touched upon in 2011, link)

In the Fixed Income Investor website, we constructed an equal weighted price average of a basket of PIBS to judge the sector movements (see here). As seen below, the index registered a steep drop in the second quarter, from 118 to 103.5 (see below). This decline was caused by:

1) The ongoing weakness in the government bond sector;

2) Co-op’s messy capital raising exercise, following its shocked capital inadequacy;

3) Nationwide’s capital shortfall, as highlighted by the Bank of England.

In summary, the sector crumbled under a mini ‘perfect storm’. Financial Times recently reported that Nationwide, UK’s largest building society, faces a £2 billion capital shortfall (link). This sum is also mentioned by the ratings agency Moody’s (link). Facing a potential restructuring and dilution, investors decided to abandon the sector.

But a crisis leads to opportunities. The Nationwide 7.25% PIBS, for example, plunged to near 70 before rebounding sharply. At the time of writing, it is trading around 90-92, with a yield (gross) of about 8%. You can find a list of leading PIBS from Canaccord Genuity here.

Judging from the sharp price rebound on this bond, is the crisis is over? I think not. As Moody’s pointed out today, Nationwide may face some more liquidity problems as it attempts to raise capital to satisfy the regulatory framework. Also, the building society may look at all financing options, of which one of them is a listing. But for most of us, the interesting question is this: How low will Nationwide’s bonds go? To answer this, I take a quick look at two previous funding crises.

Reference point one – the Global Financial Crisis of 2008. Major investment banks were collapsing like dominoes. Barclays was no exception. As investors stampeded out of the banking sector, Barclays’ 7.125% bond jumped to near 19% in early 2009 (link). After the crisis subsided, this bond dropped to 6% just 12 months later.

Reference point two - the European banking crisis of 2011. During the summer of 2011, European commercial banks were crushed by the sovereign debt crisis in PIIGS. Their counterparties either ceased business transactions with them or demanded higher collateral. This pushed the Societe Generale 5.4% 2018 bond to 12% in late 2011 (see here). But the €1 trillion LTRO saved the banking system. A year later, the bond traded at 4.5%.

But readers may argue that the problems surrounding the building societies were quite different. True, but I think the above events are highly applicable. The central theme linking all these crises is capital; these financial institutions were all in dire need of more capital and were desperately raising money from all quarters. Fears of a liquidity crisis – and in some cases, solvency - hammered bond prices badly. This pushed yields to level where prospective returns outweigh the known risk.

My view: As Baron Rothschild shrewdly observed: “The time to buy is when there's blood in the streets.” I am sensing blood in the sector – but not enough. Prior funding examples typically see double-digit bond yields before the crisis subsides. Therefore, I would not rule further buying opportunities in the sector as prices weaken ahead of the institutions’ fundraising exercises. Also, I would stick to the largest entity – Nationwide – as liquidity is better.

Dr Jackson Wong

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