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Bond of the Week: 13 December 2013

Nationwide (10.25%??) CCDS issue

    

Nationwide has issued a CCDS (Core Capital Deferred Shares) bond. In truth it is not really a bond issue but a share. However, it has appeared in and will be traded by the bond market. Because of its (probably) fixed like return, I think it appropriate to comment here. I should add before we start that while Bond of the Week addresses bonds that may be of interest to the activist retail bond investor or wealth funds, Nationwide and its advisers and the lead managers of the issue have absolutely bent over backwards to insure that as a new issue the CCDS was not available and could not leak into the hands of a retail investor. This started with, but was not limited to, a minimum investment size of £25,000.  There can be no doubt that this requirement to ensure only large institutional investors could buy this CCDS bond as a new issue was introduced with the full knowledge and indeed encouragement if not even with the requirement of the PRA (Prudent Regulatory Authority).  However, should you be interested and are able to invest the minimum amount of £25,000 then this issue will be available on the secondary market, post 12th December. Before commenting further here are the edited terms of the issue:


Issuer:                   Nationwide Building Society
Instrument:          Fully paid up, irredeemable, Core Capital Deferred Shares ("CCDS")
Size:                       £550 million
Settlement:          6th December (T+7)
First distribution date:  20th June 2014, thereafter semi-annually
Regulatory Treatment:     Core Tier 1 Capital/ Common equity Tier 1 Capital
Listing:                  Standard Equity Listing on the London Stock Exchange
Status                    Most junior investment in the Society, ranking junior to all creditors, including subordinated creditors and PIBS holders.
Accounting Treatment:     Equity
Distributions:            Fully discretionary, non-cumulative [Indicated to be 10.25%]
Distribution cap:         Capped at £15 (adjusted for UK CPI yearly) per CCDS per annum,
June Distribution:      Likely to be £5.125  (ie 10.25%)
Member Voting Rights:     Attributable to Nominee who will not exercise the voting rights at general meetings of the members
Minimum Tradable Amount:  250+1 CCDS (£25,000 + £100 thereafter)
Denominations:            £100
Joint Bookrunners:        BofAML/Barclays (B&D)/J.P. Morgan Cazenove/UBS  INVESTMENT BANK
ISIN:                     GB00BBQ33664
Now trading at:   111-112

Nationwide is a UK systemically important financial organisation with a £193 billion balance sheet. It is clear that since the financial crisis started the regulatory authorities will have had a very good look at their books which gives comfort. Trading conditions have recently been improving for banks, particularly following the Funding for Lending scheme (just cancelled by the BofE). This can be seen in improved profit figures. Nationwide’s last 6 monthly figures show profit up from £103 million to £270 million on the back of an improvement in net interest margin (spurred on by Funding for Lending) of £194 million. Where might any weakness lie? As with other mutuals (Co-op, West Brom etc) it is in their commercial property loan portfolio, and this they highlight themselves in the prospectus for this issue. Commercial mortgages account for 11.6% of Nationwide’s total loan portfolio with retail and office mortgages (3.2% of loans) a particular problem. Since the end of 2012 provisioning for commercial loans has been elevated and in the last half year it was £225 million up from £193 million in the previous half year. I would expect this to continue as banks, and building societies in particular, tend to be rather slow at coming clean with impairments – hoping no doubt to squeeze them out over time as and when they can be paid for by improved profits coming with the economic cycle. Why have commercial loan portfolios proved to be a particular problem for mutuals? If major banks were plagued by the bonus culture resulting in elevated risk positions being put on, building societies, denied the chance to dip their hands directly into the honeypot of the financial boom, as mutual tendered to suffer instead from cronyism. Lending was frequently made on the basis of relationships and who knew whom. Doubtless it was all washed down with pints of Carling and a visit to the local Indian; maybe even an outing to the local golf club or to see some dancing girls? And unlike with the banks, no actual profit was required in order to participate. And losses from any injudicious loans would take years to appear in the accounts. In Nationwide’s defence this would have been worse in the smaller regional societies than a much larger building society such as they are where I imagine there must have been centralised controls. Indeed we should not over labour any weakness in the commercial loan book, however, because, notwithstanding any peccadillos a la fleur reverende that may or may not have influenced the commercial loan book, I, like the market, still consider Nationwide a good if not the best financial credit. Commercial loans at 11% and shrinking is not an unmanageable amount given Core Tier 1 capital of 14.2% and annualised underlying profits of £664 million. With 11% of the residential mortgage market they remain a force to be reckoned with. The real question is the terms of the bond.

Given this bond or share is a new instrument, the precise terms over which Nationwide and the PRA have been wrestling for months if not for more than a year, and given the prospectus stretches to 427 pages, you might imagine your correspondent, especially as he has been accused of verbosity if not pedantry by some (thank you Mr. G. of Canaccord) , to descend into interminable legalise in attempting to describe the way this issue works. But that is not the case. This issue can be summed up succinctly. It is a case of “Give us your money and we’ll see you alright.”  In order to be able to count as Core Tier 1 capital (ie equity), with the ever more stringent domestic regulatory requirements, Basle accords and EU directives it has proved impossible for the bond to give any precise and meaningful assurances as to what the owner is entitled to. In effect you will get what you will get but unlike with an ordinary share you have no control over the process. You cannot vote in any meeting and you have no control over the board of directors. Given this is a highly unsatisfactory state of affairs from the point of view of the owner of the issue, this total flexibility as to the return, if any, an investor will receive has been balanced with a very clear indication that the next coupon (June 2014) will be 10.25% and that this coupon will be stable . In other words without announcing it as such you are being led to believe that this issue will have a coupon for the foreseeable future of 10.25%. Since it is franked income it could then be compared to a bank preference share – say the Lloyds 9.25%, trading at a yield of 7%. As such with a 10.25% coupon it is very good value.

Let us look briefly at what the prospectus actually says. The distribution policy is made very clear on Page 5 of the prospectus (which can be found on the Nationwide website): “The declaration of Distributions by the Board is wholly discretionary and therefore investors in the CCDS cannot be assured of a regular (or any) return on their investment”. It is also a non-cumulative issue: on page 22 of the prospectus, under “Key Risks of the CCDS” it says: “.. If at any time the Board elects not to declare any interim or final Distribution, no Distribution or other amount in respect of the relevant period shall accumulate.” So how are you protected? You are protected by the principles of mutuality:  the distribution will amongst other things be influenced by “the benefits received by other members of the Society through the operation of the Society’s business in accordance with the principles of mutuality;” I asked Nationwide whether an owner would count as a member of the society. The answer is yes but you only get one vote however many you own and this vote is controlled by a nominee over whom you have no control. In addition, and this works both ways, the prospectus states the board has “subject always to applicable law and regulation…the following overriding fiduciary duties and principles:

• the duty of the directors to act in the best interests of the Society;
• the duty of the directors to have due regard to the interests of all categories of member, both current and future, of the Society; and
• the principles of mutuality that apply by virtue of being a building society.

As previously mentioned every attempt was made at new issue to prevent the CCDS falling into retail hands. As well as a minimum investment size of £25,000, these shares cannot be traded in Crest but only Euroclear and Clearstream, thereby eliminating half the UK stockbrokers. I did suggest to Nationwide that this was the reason the CCDS could not be traded in Crest, but they denied this had anything to do with it. I am not convinced. On the other hand it does state in the prospectus that the minimum investment amount could be reduced in future although they have no present intention of doing this.

Given there is no fixed coupon/ dividend and you also do not even know whether you will receive this variable distribution you would expect this issue to trade “dirty” or without accrued interest. This is how all the preference shares trade. Indeed this is how Mr. Edwards of Canaccord quite reasonably trades it on the Exchange. However, the lead manager Merrill Lynch and the other investment banks trade this “clean”, like an ordinary bond, in the over the counter market. In other words you pay or receive accrued interest when you trade it. How is this possible, if to qualify as a capital instrument? Your return is uncertain and it is therefore theoretically impossible to calculate accrued interest. I posed this question to Nationwide, and, if I understand the answer correctly, it is that the dividend that is declared is forward looking so you are able to calculate accrued interest (even if the dividend can be rescinded); All very rum. Exactly the same thing could be said about all preference shares which have fixed coupons.

Quite a few years ago passing through Paris on my way to Italy, I stayed with an old friend of mine. The son of a Vicar he had run off to Paris with a Sergeant in the French horse guards and was living in a small one-roomed garret in the Rue de Fauborg St Honore. As I paced the room eying the sofa where I was to sleep and waiting for my friend to come out of the shower I stretched out an arm and grabbed a book from the bookshelf. Perhaps I should say I nervously grabbed a book from the bookshelf. [Don’t worry, this is not about to develop into a bedtime story for our friend the Rev. Flowers].I sat down to read it where it fell open at a point midway through the book; a book covering some of the more idiosyncratic aspects of the Jewish religion. The chapter dealt with what a Jew may ask a gentile to do for him that he may not be allowed to do for himself because it is the Sabbath day.

The Orthodox Jew may not, for instance, drive a car or switch on a light between sunset on Friday and sunset on Saturday. It would of course be quite wrong for him to solicit another Jew to perform these tasks. However, the gentile is covered by no such restrictions. The question is how is it possible for the Jew to convey to the gentile that he would like such and such to be done without issuing an instruction which would be tantamount to employing the non-Jewish party to perform an action and would therefore be as if he had done it himself. The answer was to hint. So our friend the Observant Jew exiting the synagogue and not relishing a long walk home, perhaps tired after a particularly strenuous day of bobbing and swaying, incanting and intoning, and coming across, by chance, his neighbour, a gentile, may not exclaim “ gissus a lift”. He may, however, hint. “Rather a threatening rain cloud over there; ooh a bit of a stiff back today; expect you are off home now for a good cuppa tea. Ah that’s the new car you have been talking about”.

Likewise our friend following a small procedure finds himself detained over the weekend at a small cottage hospital.  As Friday sunset approaches the light rapidly dims and he can hardly make out the book within the book he is meant to be reading (even if it is mostly an illustrated offering). He espies a comely nurse coming down the corridor. Can he shout “’allo gorgeous! Turn on the light for us, darlin’!”? No he cannot. Instead: “You’re looking very comely this evening Matron.” He arrests her advance. “Look at my splendid flowers from Rabbi Smirsh’ s wife, the wonderful Jacquie”. He entices her into his lair. “Careful with the wires on the floor; visibility not so good in here.”. He pounces with the hint. You may think I am making this up. I am not. I may be no Talmudic student but I did check this with my good friend, colleague and chauffeur H. who was in just this predicament as to what he could and could not do. But enough of this; here ends this digression and let me explain why I make it.

Such are the stringent new regulatory requirements for the issue of capital for building societies, this new instrument operates by hints. investors cannot be offered any definite return with a CCDS but heavy hints therefore need to be dropped. Nationwide has been as clear as they can be without actually being clear that the return for this CCDS will be 10.25% on an on-going basis (for now at least). They have announced next June’s dividend to be 10.25% and have emphasised they expect the distribution policy on the CCDS to be stable. When asked what the future holds they keep using the word stable. I am sure Nationwide will have had private meetings with major funds, prior to this issue being launched, and I am sure the words “stable returns” will have kept cropping up all the time. The decision to trade this issue with accrued interest is another clear sign and reassurance that they intend to keep paying the same dividend.

In the same manner (of declaring one thing but hinting another) there are warnings all over the prospectus to keep retail investors away. But even in this there is a suggestion that maybe in the fullness of time they wouldn’t mind enticing some larger more in-touch retail investors in. The £25,000 minimum investment amount is lower than the more typical £50,000 to £100,000 for most institutional deals; why if not to encourage in retail investors? There is even the possibility being held out that one day the minimum investment size could one day be reduced. In the same vein the listing on the Exchange also brings much greater visibility for private investors who are much more au fait with exchange traded products they can follow on line at the LSE’s website. When asked, Nationwide even said they were aware that some retail investors were likely to want to buy the issue in the secondary market.

This CCDS issue has been an experiment for Nationwide. They told me “We did not need to issue CCDS for capital purposes. We issued as proof of concept for the new instrument which will give us flexibility going forwards if we so choose.” By trading at a very considerable premium they have proved the concept works. However, while I have all respect for the workings of the Talmud and as a gentile I find the intricate application of logic fascinating, I do not think what is appropriate for religion is not appropriate for a capital instrument. Saying one thing and strongly hinting another is not a satisfactory affair. Prospectuses should be very clear on what they are offering bond investors and the CCDS takes us far away from clarity (unless you conclude that stating boldly that there is no clarity is a clear statement itself). Also hinting can only take you so far. Here I pose three of the questions that hinting cannot answer:

The issue has an inflationary cap although for now I understand stable distribution means actual rather than  real or inflation adjusted stability. However, if many years down the road inflation has eaten away at the return and say the inflationary cap has moved up from £15 to £30, will they then upgrade the distribution? I do not know and I expect they do not know. You might add why indeed do they have a cap and why is it inflationary linked; what if any is its purpose or justification?

Should Nationwide get into severe trouble resulting in the loss of a substantial part of their capital and no distribution for the CCDS but nevertheless eventually return to health, what then? Will the 10.25% dividend return or will they say that during the crisis a substantial part of the CCDS equity was wiped out so future payments will be much reduced on a continuous basis? I do not know and I expect they do not know. I note that unlike other recent capital innovations no mention is made of write-downs of capital – presumable because CCDS are shares not bonds.

What happens if profits double or quadruple over the next 5 to 10 years, could the distribution increase? In the short term I would say no but in the distribution policy the first factor it mentions in determining the distribution “is the profitability of the Society and its resources available for distribution;” So who knows in the fullness of time. I do not know and I expect they do not know. This question is linked to the previous one. Any principle that allows them to permanently diminish the dividend surely would make them beholden to permanently increase the dividend should the inverse be the case.

What I can say is that for the foreseeable future there should be plain sailing with regard to what an investor will receive. Nationwide cannot afford to let this new instrument that they have worked so hard to create with the PRA to fail. It would make a complete nonsense of what has been a very expensive issue/ experiment for them to do something silly (ie not pay the 10.25% coupon). They would destroy not only CCDS as a method of raising capital but also their good name in the market with investment funds.

So what have I done? Notwithstanding the criticisms I have made, I think that with this CCDS novelty pragmatism wins over principle; for now. Asked by someone what I thought of the issue before launch, I said it was all very well putting on a sandwich board and proclaiming the short comings of this issue, but you were likely to be mown over by hoards of swivel eyed investors frothing at the mouth and shouting yield coming your way; a bit like one of those scenes in the Evil Dead. I said, moreover, that I intended to be one of those investors. In fact I am not sure whether at that moment, like Pavlov’s dog, I did not start to froth myself at the thought of 10.25%. I came into the office very early for me to be there at the open (7.55am). Despite this the first offered price I saw immediately after launch was 107.50 – an amazing premium for a just-issued bond. I closed my eyes and bought. The price grinded up and I bought some more at 108.50. The last offer I saw was at 112.50. I expect it is going higher and 120 is a not unreasonable target in the near term. Given the risk associated with this CCDS I do not make a recommendation – although maybe a hint at one -but only suggest that for you, assuming the minimum investment size is not too large, you should consider whether pragmatic trust in Nationwide wins over the shortcomings of the prospectus. I think it does but you may disagree. I would also suggest this instrument is more appropriate for someone who is an activist investor. Or put it another way:  someone who keeps his eye on the ball and gets out when he has a fat profit or can see the direction the wind is blowing in has changed.

Oliver Butt is a Partner in City and Continental LLP, a leading independent broker in fixed income. The author and or the LLP may hold a position in or trade in any of the securities mentioned above.

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