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Bond of the Week: 15 February 2013

Paragon Group of Companies PLC 6% 2020


Paragon, a FTSE 250 company, has launched its debut retail targeted bond. I start with a position of goodwill towards this company as an investment in their shares has been one of my few equity investments in the last few years and it has been an unusually positive experience. The shares have risen from around 40p in November 2008, (the chronological epicentre of the financial debacle) to 300p today. Unfortunately I cannot say I got in at the bottom and I certainly sold too early (at 214p). Nevertheless the company is obviously doing something right. Here are the terms.

Issuer  Paragon Group of Companies PLC
Maturity 5th December 2020 (7 years and nine months)
Issue Price 6.00% (semi-annual, Sep/March)
Min Subscription  100
Books open £2,000
Books Close Now
Status Senior, 

26 February 2013 - 5pm (subject to early close of offer period)

Distribution UK, CI & IOM only
Settlement  5th March 2013
ISIN XS0891023086
Listing London  ORB
Sole Bookrunner Canaccord Genuity Limited

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

But clients of Paragon (a specialist Buy to Let lender) would beg to differ with the Bard. Most of them have managed to husband their resources very well by borrowing. They have not only gained independence from institutional investment advisors, but are also likely to have outperformed equity market, pension fund managers and a myriad other collective investment schemes (although not, of course, specialist bond managers!).

Buy to Let (BTL) has been one of the surprising success stories of the current crisis. In the darkest hours of 2008 it was assumed that the knock on effect of the financial crisis would be a fall in property prices, a fall in the rents that could be charged and an increase in vacancies which would send many BTL landlords over the edge. In the spirit of that pervading opinion Bradford and Bingley, a better known provider of mortgages to the BTL sector, was nationalised without compensation in the Autumn of 2008. The bank could no longer fund itself in the wholesale markets, the government offered no liquidity (unlike with Lloyds and RBS) and no white knight rode to the rescue (Santander took over Alliance and Leicester at that time). Buy to Let was deemed too toxic. Paragon, however, survived, with a timely rights issue paying off their existing bank debt.

Buy to Let landlords did not, however, suffer the fate that was allotted to them. The nationwide fall in property prices has been limited and in London prices have resumed their strong upward trend. Even if landlords are underwater on the value of their houses and flats they have benefited from record breaking ultra low interest rates and at the same time steadily rising rents, significantly improving their cash flow. Landlords’ purchases have changed from a capital gain to income producing proposition. Anecdotally I have checked this with our resident Buy to Let expert Sanjay, and he confirms it is as I say. Were it not for the unexpected flow of income from his investments he claims he would not be able to afford to work here. Interestingly if you look at the arrears figures for Bradford and Bingley they are lower than for the supposedly better quality book of the other nationalised UK bank Northern Rock. On top of that BLT mortgages will have better LTV ratios and higher lending margins, both to protect the mortgagers from the supposed higher risks involved. 

With the favourable background of BTL mortgages Paragon has prospered and not least because much of the competition has been removed. Here is some basic information about the company. They were launched as a specialist lender in 1985 and now have a loan book of £9.6bn (which would make them the equivalent of the 5th largest Building Society) and they have around 350,000 active accounts. BTL mortgages constitute £8billion and consumer lending £1 billion of the portfolio. They have an impressive record at generating profits and were profitable through-out the current crisis. 2012’s group profits were a record £95.5million, up from £50million in 2008. They also have good cash flow of around £100 million per annum.

With margins much higher and LTVs lower on new business, new mortgages are more profitable than legacy/ pre-crisis business. In addition to writing new business they have also purchased nine loan portfolios worth over £3billion. Most of these are consumer loans which are higher risk, involve more costly administration but have much higher margins and run off very quickly. Banks have many more potentially juicy disposals to make in order to achieve required capital levels and doubtless Paragon will be picking over them. My observation is that one of the crucial ingredients for a financial company to emerge from the current crisis in robust health is to be able to write new business/ buy existing portfolios at attractive prices. Lack of capital forcing the rundown of loan books with no new business being added locks a financial institution into low margin business and compounds any problems they may have. They will have no profit to pay for tomorrow’s mistakes. Happily Paragon is not in this situation. 

The particular strengths of Paragon are two fold. Firstly they take no interest rate risk. Paragon does not take deposits and therefore all their mortgages, bar a short period in which they are warehoused while sufficient volumes are accumulated, are securitised. Any interest rate rise will only have a modest effect in two indirect ways: A) Paragon will earn more on their own equity (roughly 10% of the loan book) and B) by potentially undermining the credit quality of their book. Unless rates were to go stratospherically higher A is likely to positively outweigh B. Paragon’s other strength is their expertise and experience in managing and administering a stream lined mortgage business. Their attention to detail results in very impressive arrears figures. As of the 3rd quarter 2012 arrears on all CML (Council of Mortgage Lenders) is 1.93%, CML Buy to Let arrears were a better 1.51% (bearing up the Bradford and Bingley/ Northern Rock experience) but Paragon themselves had an excellent arrears rate of 0.48%. Paragon also earns money providing loan servicing to third parties (eg hedge funds) who are otherwise competing with them for the purchase of portfolios.

Conclusion: Paragon’s business model is simple. They provide Buy to Let mortgages and some consumer lending. All their lending is securitised and therefore match funded so eliminating both interest rate risk and any possible liquidity problems. They could not suffer a run on the bank like Northern Rock as they have no depositors. They have proved themselves throughout the financial crisis with an unbroken record of profitability. In addition the future looks attractive as banks will continue to shrink their balance sheets both reducing competition and eliminating any pressure on margins. There should also continue to be many attractively priced loan portfolios on offer as other financial institutions exit lines of business. The only real risk to the business is a sustained and substantial fall in the property market and a decline in chargeable rents. This seems unlikely given incipient inflation, a lack of housing stock and continued immigration (next stop a population of 70 million). The 6% coupon therefore seems generous (I was predicting 5.75%) despite Paragon being a financial company. The maturity (2020) is reasonable so interest rate risk, with rates likely to remain low for quite a few years, is limited. I therefore recommend a strong buy. I expect quite a good premium to develop on this bond as supply is probably capped at £75million and the ISA season is round the corner. Come to think of it, I may even put my mother into it!

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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