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Bond of the Week: 24 May 2013

Bond of the Week: War Loan

    

War Loans are falling again. The bond, which traded around 101 a year ago, spent the last twelve months retracing the climb. For investors who bought in the nineties, what now? Should they sell, or hold?

War Loan is an interesting instrument. The bond is structured with a perpetual maturity but the government can redeem the instrument at par (100) if it is in their interest to do so.  In late 2011/early 2012, talks were rife about this possibility, as long-maturity gilt yields were falling sharply. But the anticipated redemption did not materialise. Why? Perhaps the Treasury thought the borrowing rate of 3.5% was close enough to the yield curve and was not worth replacing it.

Whatever the reason, the bond’s relative spread against long-maturity gilts is widening once more. At 4.1%, the War Loan currently yields about 70bps more than the Gilt 2060 despite both bonds having similar credit. Admittedly, War Loan is a slow and illiquid asset. Unlike gilts, the bid-ask spread for War Loans are fairly wide. The standard spread quoted in Bloomberg is 2.5 point. Another reason for the extra compensation over gilts is the optionality attached to the bond. While long-maturity gilts may trade significantly above par, the upside for War Loan is capped, primarily because the government can, and may well, redeem the bond if it trades above par.

Specifications:

  • Issuer: UK Government
  • Coupon: 3.5%
  • Yield: 4.1%
  • Currency: GBP
  • Size: £1,950.8 million
  • Features: Perpetual callable @ 100.00
  • Rating: Fitch (AA+)
  • ISIN: GB0009386284

View: Judging from War Loan’s long-term chart, the bond is a predominantly ranging instrument. During 2003-2011 the bond strictly traded in between 70-90, with few, sustained, excursions outside this range (see chart below). Therefore, I would expect this bond to extend this trend over the next few years. And because of the bond’s adverse optionality, I do not expect the bond to trade significantly above 100.

However, I did notice this: The floor for each trading range is raised over the years. During 1998-2003, the lower side of the range is 65. This became 70 during 2003-2011. As the Bank of England is set to suppress interest rates further with quantitative easing, I would not be surprised if this floor is now raised to 75 for the next few years. In 2011, we advocated a buy in the instrument when the bond was trading near the range floor (see here). I favour the same tactic now. For those on the sidelines, I would watch to buy the bond near 75-80 as this gives investors a better risk-reward on the trade. For the majority of the holders, I would continue to hold the bond as it offers a good cushion against conventional gilts, but I would look to add in the mid-seventies and lighten when prices rally back to par.

SourceFinancial Times, see here

Source: Bloomberg

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