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Bond of the Week: 3 June 2013

Investec Impala Bonds.

    

I was approached a few weeks ago by the specialist bank Investec, one of the main movers in the retail bond market, about an idea they have been working on. They have created a mechanism for issuing bonds that are derived from existing retail and institutional bonds. Generally Bond of the Week would not be the place to discuss structured products, and these are a form of structured product. I assume readers of this column would like a discussion of bonds with the simplest of structures; an issuer, a fixed coupon and a maturity date (and in the case of last week’s Co-op 13% ex PIB, just an issuer and a coupon!).  Personally I also have a general prejudice against structured products since they often seem to be designed to decrease understanding and increase fees. Nevertheless there is always the exception and the Investec proposition has a number of unusual features that makes it at least worthy of passing interest for those who follow the fixed income market. I should also add that the bonds that have been issued out of the Impala programme are fairly straight forward, even if there are various swaps going on in the background.

But first, what problems does the bond investor face in today’s financial market and why might the additional choice that Investec’s Impala bonds represent be an advantage? I think the case I made on the 10th January, “Where to Guv?”, essentially holds. Yields are low, interest rates cannot be raised in the foreseeable future without seriously jeopardising financial stability and inflation continues to take its toll. There are still some opportunities in taking credit risk (ie playing on further yield contraction between corporate debt and government bonds) but they will normally come attached to duration risk. Can you be certain there will not be a gilt sell-off, with 10 year yields sub 2%, even if base rate does not rise? In the past a passive approach to investing in bonds (choosing an acceptable yield and credit and then sitting on your purchase) has been perfectly rational. It is much more difficult to make that case today given the low absolute and negative real yields the investor has to deal with, not to mention the continued dislocation of the world economy with its associated threats to your investments. [I would add here that the superior yields available in the retail bond market make it one of the few places where you could still justify a passive approach.] What the bond investor needs is flexibility and choice. Hence my interest in what Investec had to say.

For years bonds have been restructured, asset swapped, currency swapped, insurance wrapped etc. etc. in the institutional market. At the point this happens the bonds, being held until maturity, disappear from view and only resurface when something has gone wrong with either the issuer or the investor. These bonds are of no interest to the retail investor if only for the simple reason that they are never available except in chunks of a million or more. Investec however, has created a mechanism, targeted at private client wealth managers, where liquidity (in retail size) should be maintained for the life of the bond. At this point without going into too great technicalities we should look at how these new bonds are created and how they work.

What are the mechanics of these Investec bonds? Investec purchases an initial portion of the underlying security and carries out the intended swap; the swap and the bonds remaining on Investec’s balance sheet. This is the crucial difference compared to a standard structured swap where the bond will effectively be placed in an SPV (Special Purpose Vehicle). Once in an SPV the size of the issue can neither be increased not decreased.  The new bonds become an entirely independent entity and therefore they invariably have extremely poor liquidity. To revert to Investec’s structured product, the underlying bonds having been purchased are placed in an account with Deutsche Trustee Company Ltd who hold them for the benefit of the holders of the Impala bond via a fixed charge. Although the underlying bonds are held for the benefit of the new bond holders (and the fixed charge on the pool of assets protects the interest of the holders of the Impala bonds in the event of Investec’s failure) the underlying bonds along with the swap still sit on specialist bank’s balance sheet.

How is liquidity maintained? The trader/ market maker at Investec may well hold a small trading position in the Impala bond. However, should there be any persistent buying or selling then the trader can go into the market and either purchase or sell the stock of the underlying.  These bonds are then added to or subtracted from the account with Deutsche Trustee and consequently either new securities (of the Impala bond) are issued or cancelled. At all times the stock held with Deutsche Trustees will equal the amount of outstanding bonds held by investors (and any portion held by Investec’s trader). The crucial and unusual aspect of the way that Investec has arranged this programme is that the new bond not only maintains liquidity but should have the approximate degree of liquidity of the underlying asset as the Investec trader is able to off-lay all of his trades in the Impala bonds directly into the market. [Please note here that if liquidity in the underlying dries up so liquidity in the Impala bonds dry up].

The final point on liquidity is that Investec’s new bonds are listed on the London Stock Exchange under the auspices of the UK Listing Authority (UKLA). The UKLA check the prospectus and check that the bond is compliant with all EU regulations. It should be noted, however, that the bonds are not traded on the ORB platform and at present Investec has only made a commitment to post prices on Bloomberg. However, they are in the process of getting the Impala bonds admitted to SEAQ, the system used by the professional market to trade both equities and bonds. Admission to SEAQ comes with an obligation to make prices with minimum spreads and sizes.

What are the costs? The costs of the Impala programme are very transparent and do not rely on turnover. There is a cost of 25 to 50 basis points when the bond is launched. To be technical, the variation of the charge comes about because of the differing credit risks of the underlying bonds and the effect of the duration of the relevant Impala bond on the capital charge to Investec’s balance sheet.  There is also a tiny charge of 1-2 basis points for the cost of putting on or unwinding the swap when a trade is done. No money, when trading Impala bonds in the secondary market, is made on the bid/ offer price.

What happens in the event of Investec’s bankruptcy? In that case the bonds are cancelled and you will receive the value of the underlying security plus the swap. It would then be possible to go into the market and buy the underlying security should you so wish.

To date Investec has only launched two new issues; one derived from the LSE 4.75% bond and one from the Barclays 14% perpetual. In both cases the bonds were swapped into a floating rate form (ie they pay a spread over Libor). However, the issue here is not, I think, to discuss the merits of individual bonds launched under Investec’s programme but rather the idea of the whole approach. As discussed in the second paragraph above, the bond investor in today’s difficult markets needs flexibility. I list here some of the possibilities.

You may own a bond that is trading at a very high premium. Any profit made from selling will be free of capital gains tax (as a QCB) but you still like both the credit and the credit spread. If there is an Impala bond in the market you can sell the underlying, purchase the new stock and pocket the gain free of tax. This could/ can be done with the Barclay’s 14% issue. It is possible to sell the issue at around 135% and purchase the Investec Barclays Impala bond issue yielding Libor+500 (the contractual spread is Libor+490 and the market price is 99.43).

It should be possible to issue a bond that is linked to RPI. The advantage here is that most or indeed all RPI linked bonds that are available in the market are for popular issuers such as utilities (National Grid and Severn Trent for instance) and therefore they trade at a very tight spread. Recently real yields in the sector have been close to zero and in the case of gilt linkers rates, real yields have been negative for some time. Using Investec’s programme it should be possible to take a bond with a decent credit spread, such as the Barclays 14%, so that post the swap into an RPI linked bond there is a good positive spread over RPI inflation.

One of the main enemies of choice has been the EU directive, brought into being to protect small investors, which discourages issuers from issuing in denominations of less that £100,000 (unless the issuer wants to pay for additional onerous and expensive work on the prospectus). It should be possible, in the process of swapping a bond under Investec’s programme, to reduce the denomination from £50,000 or £100,000 to a more reasonable £1,000.

Again it may be possible to switch a bond into a foreign currency; anyone fancy a Norwegian Krona or Brazilian Real bond issued by a name you are familiar with and tradable in London? As with linker issues there is a tendency for bonds that are available in a foreign currency (other that USD and Euros) to be issued by top quality Aaa names with consequentially low credit spreads. I would certainly be interested in a foreign currency bond where you could combine the attraction of the foreign currency together with a credit risk derived yield enhancement. I understand from Investec that foreign currency swaps can be onerous on the balance sheet so there may be an extra but not huge swap charge when issuing in a non-Sterling format. 

I could go on listing possible advantages of Investec’s Impala programme. It is early days yet and there are only two issues to date but the essential point is that the concept is interesting. The on-going liquidity is a crucial part of the attraction. Of course as an individual investor you can only take a re-active approach to these Impala bonds. You cannot make a suggestion of what you would like (unless you have a couple of million to spend). The Impala bonds will not be directly available as a new issue (for regulatory and practical reasons) to retail investors. However, I like Investec’s contribution and therefore you should keep an open mind if offered one of the issues in the future and at the least it is academically a very positive move by Investec to broaden choice in the market.

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