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Bond of the Week: 10 September 2010

Yorkshire Building Society Society Contingent convertibles offer 11% yield.........

    

I last looked at the Yorkshire 13.5% 2025 contingent convertibles in February. Then, the Yorkshire and Chelsea building societies were in the throws of a shotgun marriage, with the gruff no-nonsense northerner rescuing its southern counterpart. During this bail-out and refinancing process, the holders of PIBS and other subordinated debt carried most of the pain, with holders of such bonds forced to take a 50% "haircut" on their investment in order to boost the capital of the newly-merged society. Out of this deal came a new security, the Yorkshire Building Society 13.5% 2025.

This instrument is what is known as a "contingent convertible". Building societies can not issue equity, so in order to improve their capital ratios, the YBS and its bankers launched what is effectively a hybrid bond.  The key feature of the contingent convertible is this - if the building society’s tier one capital falls below 5%, the bond holders will suffer a forced conversion to "PPDS" - profit participating deferred shares.  Should this event happen, it would not be a happy one for the bond holders. Dividend payments for PPDS are related to the profits of the company and are discretionary. Thus the risk associated with this instrument is higher than that on a conventional bond.

The details of the security are as follows:

  • Issuer: Yorkshire Building Society
  • ISIN Code: XS0498549194
  • Coupon 13.5% (semi-annual)
  • Maturity: 1st April 2025
  • Issue size: £100 million
  • Min piece: £500
  • Features: Conversion trigger if issuer’s Tier 1 ratio falls below 5%
  • Credit rating: BB+ ( Fitch)
  • Callable: no 

Since the launch of the new amalgamated issue, the market price initially ticked up into the mid-twenties, but has declined since currently languishing in the ’teens, considerably underperforming its peers. Why might this be so? I would suggest that the fundamentals for the security are positive. Yorkshire’s half-year results, released in June (click here to download), showed the Society swinging back into the black with core operating profits at £53 million. The balance sheet looks sensible with member savings on the increase, supporting 97% of loans. Capital ratios are strong with core tier one at 11.8%, slightly up from the 11.1% seen last year.

I suspect that the poor price performance may be related to the lack of visibility of this security. Unlike most PIBS or preference shares, the Yorkshire bond lacks a LSE quote and is rarely featured on broker’s lists or in the online chatrooms favoured by enthusiasts of these instruments.

The market price of the security is currently in the mid-teens. At 115, the yield to maturity is 11.4% somewhat higher than the yields offered by the majority of PIBS, preference shares and ECNs. Another advantage of the new security is the low minimum size. The refinancing deal needed to accommodate the previous "shapes" of the precursor securities; £50,000 for the Yorkshire PIBS and £1,000 for the Chelsea subordinated bonds. After factoring in a 50% "haircut" on the deal this left the new bond with a £500 minimum denomination. This smaller size is an extremely useful side effect of the deal, enabling private investors to scale their purchases according to the size of their portfolios.

My view:   The UK PIBS, preference share and subordinated financial sector has performed strongly this year, and in general offers rather lower yields, and thus less value, than was seen at back in February. The Yorkshire 13.5% 2025 has lagged this rally and is one of the few instruments still offering a double-digit yield.   

The 11.4% yield is attractive and in my view adequate compensation for the risk, particularly in view of the solid results from the newly merged society. I view the bond as a buy, and I intend to purchase a holding for the www.fixedincomeinvestor.co.uk model portfolio. However, I would stress the point that this bond should be held as part of diversified portfiolio. This is particularly important for subordinated or hybrid instruments, where the risk of default or other credit-driven events is higher than a conventional bond. Investors should also be aware that the relatively poor transparency/liquidity situation may mean that liquidating the security ahead of the redemption date may be difficult, particularly in adverse market conditions.

Mark Glowrey

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