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Floating rate bonds as a hedge against rising interest rates

Some interest coupons float higher like balloons if rates rise

A year ago I posted the article that follows, highlighting two very obscure and illiquid securities that should do well if and when interest rates go up.

One is a PIB1 from Nationwide, and the other is a preference share from the UK arm of the South African bank Investec.

In the 12 months since then, the price of the first has risen 10%, while the second is up 34%.

Superficially, this doesn’t make sense. Interest rates have not risen, and so the floating rate element of the coupon has not adjusted upwards. All that’s happened is that the higher price has pushed the already tiny yields down for new money, meaning the securities are now paying just 3% or so on purchase.

I believe what’s happening is that investors are now valuing the built-in floating rate protection more highly, given that an interest rate rise in the UK no longer seems about as likely as Charles becoming King.

Unemployment stands on the threshold of the Bank of England’s 7% target for rate rises, and the UK economy is starting to pick itself up. It’s not pretty to look at and it’s as unbalanced as a Friday night drunk on a Saturday morning, but it’s definitely still alive.

Gilt yields have also responded. In Spring 2013 the ten-year gilt was yielding below 2%; this month it briefly crossed over the 3% mark.

I don’t think Bank of England governor Mark Carney has any intention of raising rates yet, but they must rise eventually if the economy keeps mending. Once that happens, the only way these instruments are likely to go is up.

I’ve therefore republished the piece for interested souls ahead of any such hike.

Please note:

  • I’ve not updated the numbers or anything else in the article. Currently CEBB costs 85.25p to buy and INVR 525p. You’ll have to do your own sums.
  • Clearly some of my speculation about price moves was off the market, given that they’ve already moved higher. As I say, I think this reflects the optionality of the floating rate element no longer being discounted by the market.
  • The spreads are absolutely horrendous – in the region of 10%. These are tiny issues. If they spike in price and you overpay, you could be looking at red in your portfolio for years to come.
  • The brilliant Fixed Income Investor website wrote about INVR in October, when the price was 60p lower.
  • I own a small amount of both.

I think these are interesting issues that aren’t big enough for hedge funds and the like to get involved with. They can be used to add interesting diversification to a portfolio at some cost, if you’ve got a suitably long-term mindset and are prepared to take on the credit risk.

However I repeat they are illiquid, expensive, and are best suited to sophisticated investors who know what they’re doing. You have been warned.

— Original article from 24 January 2013 begins —

Note: This is not a recommendation to buy any of the securities I mention (including CEBB and INVR). I am just a private investor, sharing my thoughts for your entertainment. Please see my disclaimer and do you own research.

The Bank of England currently has interest rates set to low. In fact, at 0.5% they’re at rock bottom.

Rates are so low that if the UK economy were a patient hooked up to a life support machine, you’d be banging the side of it to see whether the flat line was due to a valve getting stuck somewhere or a bed being freed for the next one.

Here’s a graph from MoneyWeek’s Merryn Somerset-Webb:


Yes, it’s a 300-year graph. Rates have not been so low since at least 1700!

The graph goes back to before the Industrial Revolution – back to an era when having a few sheep and a goat made you quite the catch around the hovels. It includes periods when Britain had the largest Empire the world has ever seen, and years when Blighty was in the dumpster, begging the IMF for a bailout.

Throughout all that, bank rates never fell below 2%, to my knowledge. Yet here we are today, and you can almost here the ‘beeeeeeep’ of the flatlining base rate:

Click to enlarge

Click to enlarge

Of course, the unprecedented 0.5% base rate that prevails at the time of typing is scant reward with inflation at over 2.5%.

On the contrary, the low bank rate is meant to pull down interest rates ‘along the curve’ to encourage banks and others to lend and invest in order to earn a real return, as well as to stop crucial institutions from going bust.

The resultant steep ‘yield curve’ has supported an economy that’s lurched in and out of recession in the face of a global deleveraging. Those who bemoan the bank for inflating away the cash savings of pensioners should at least consider the alternative.

Hunting for value in a low-yield world

As I suspected might happen back in December 2009, the resultant steep yield curve has also caused assets like equities to soar.

This isn’t exactly an accident – as I said, central banks want to encourage people to move into riskier assets. However I’m sure even Mervyn King and his team have been surprised by just how strong the rally has been.

As regular readers will know I’ve been very fully invested in this bull market since it kicked off back in March 2009 (and, less lucratively, before then!)

But with indices now approaching new highs in the US and UK markets getting back to their pre-crisis levels, even I’m a little giddy.

Don’t get me wrong. I’m definitely not calling the top of the stock market. Even if I thought I could do such a thing consistently, I wouldn’t do it today.

Shares don’t look cheap anymore, but in the UK and Europe they still seem fair value. I suspect prices will be much higher 5-10 years from now. I remain much more optimistic about shares than most people.

However when the Sunday papers start extolling the joys of shares on the back of them costing more to buy again – I know, go figure – then it’s only sensible to look for greater diversification.

But where? I’ve been allowing my cash reserves to build with new money, but that’s barely breaking even after inflation. UK government bonds are peerlessly safe, but the price you pay for a secure return of capital is very little actual return on your money.

The 10-year gilt is still yielding barely 2%, despite falling in price recently. I remain wary that these price falls could be just the start of a trend.

I’ve had some nice gains with risky fixed interest preference shares such as the Lloyds LLPC issue, but running yields of around 7.5% seem to me to be up with events. Besides, I continue to hold that one and I’m supposed to be diversifying.

Hunting about in the forgotten corners of the market though, I’ve found two other obscure securities that offer something a bit different – and that look cheap to me.

Two illiquid and obscure floating rate securities

These two fixed interest securities – one from Nationwide and the other from South African investment bank Investec – pay a floating coupon, instead of the fixed coupon you get from normal bond.

The coupons are linked to interest rates. As rates go up, the coupon increases, and vice versa.

Both securities are perpetuals. This means they cannot be redeemed by their issuers, and so should pay out for as long as you hold them, provided their backers are able to pay – that is, assuming they don’t go bust or otherwise have problems.

On that note, let’s begin the risk notices.

Important warning: These are illiquid and subordinated securities. If the Nationwide or Investec was to get into serious trouble, they might stop paying interest. Worse, if the bank was to go bust or require new capital, you could lose some or all of your money. You have no deposit protection from the FSA.

The Nationwide is the UK’s largest building society and it’s been a rescuer during the crisis, but its fortunes depend on what I think is still an over-priced UK housing market.

Investec is more diversified, but much of that is diversification is in South Africa. That is a bit like diversifying a hot burn you’re getting from holding a frying pan by sticking your free hand into the fire.

On a brighter note, both have continued to pay throughout the crisis – and Investec has even continued to pay ordinary shareholders a dividend. So I’ve put some money into these issues, knowing that I could lose it all.

You have been warned!

The joys of a floating coupon

It’s vital to research any bond or building society PIBS (which is what the Nationwide issue is) before you consider investing.

What follows is just some sketch notes, not an exhaustive write-up. Please do your own research using bond-focused sites like Fixed Income Investor and Fixed Income Investments, as well as material from the banks’ themselves, before making your own mind up. Do not take my amateurish word for anything.

Here are the most pertinent details.

Nationwide Floating Rate PIBS

Ticker: CEBB
Coupon: 6 month LIBOR2 + 2.4%
Duration: Undated
Bid/Offer: 70/77p3
Current yield on offer price (rounded): 4%

Investec Preference Shares

Ticker: INVR
Coupon: Bank of England base rate + 1%
Duration: Undated
Bid/Offer: 345/375p
Current yield on offer price (rounded): 4%

As you can see, there is a huge bid/offer spread on these securities, which means you should only buy them if you mean to hold them – you’ll be paying as much as 10% for the privilege of acquiring them.

I’ve had no luck dealing inside the spread. I’m not at all surprised in the case of the Nationwide’s CEBB, as the issue is only £10 million in size! (It was inherited when the Nationwide took over the Cheshire Building Society in 2008).

Working out floating rate yields

The next thing to notice about both CEBB and INVR is that their current running yields are around 4%.

I’ve discussed how to calculate bond yields before. Here the process takes one more step, because you need to work out the numerator – the coupon – first, as it fluctuates with base rates.

For example, for INVR:

Interest payable = (Coupon/price) = (BoE rate+1%/375)

= (0.5%+1.0%/375)

= 4%

Is 4% attractive? It’s a much higher rate than cash, of course, but these are infinitely riskier securities.

What about compared to other perpetual bonds, such as the fixed interest Lloyds preference share I mentioned earlier, or other PIBS? These are paying about 6-8%, so we’re getting much less for our money here in terms of current yield.

A final and important comparison is with the UK government’s perpetual obligation – the undated Consols.

These are currently paying 4%, just like CEBB and INVR, and they’re effectively risk-free when it comes to getting paid.

Why on earth would anyone buy CEBB or INVR, when you get no premium in terms of interest for the risks you’re taking?

What would you pay for 4% plus a promise?

The answer is that the coupon payable will rise if rates rise. And if you stayed awake during my introduction, you might well think that’s more a matter of ‘when’.

Let’s consider INVR again. Let’s assume the Bank of England hikes rates back to 2%, which was hitherto the lowest they’d ever been. Not too ambitious.

In this case, if we were buying at 375p INVR would pay:


= (2%+1%/375)

= 8%

A rise in rates of just 1.5% has doubled the income payable on 375p. Quite a lift! As you can see, this coupon gearing is a valuable thing to have when interest rates are rising. (Obviously it stinks when rates are falling).

In reality, if base rates rose to 2%, then people would probably pay more to own INVR preference shares, which would bring down the running yield. If you already owned the shares, you’d therefore see a capital gain.

How much would they pay? Who knows, but currently we know they seem to want to match the rate from Consols.

Back before the Bank of England slashed rates to 0.5%, Consols were paying roughly 4.5%.

If we assume that Consols would be paying 4.5% again with base rates back at 2% (perhaps a big assumption) then we might assume that the price of INVR should also rise to give a 4.5% payable rate on its higher 3% coupon.

We have to solve:

3%/price of INVR = 4.5%

3%/4.5% = price of INVR

= 667p

That would represent a capital rise of 43% on today’s price of 375p AND a holder would be getting paid more interest into the bargain.

Alternatively, you might choose to estimate your future prices with reference to the BoE base rate.

Currently INVR is paying 4%, which is 3.5% over the base rate.

We can derive a formula like this:

Price = 1000 * (BoE rate + 1% / BoE rate +3.5%)

That would imply a price of 545p with base rates at 2%.

What about CEBB? Similar maths, except the volatility is not so extreme. This is because CEBB is paying you 2.4% fixed, instead of the 1% of INVR, so the coupon gearing is reduced.

In fact, in normal times you might not expect the price of CEBB to move much at all. The price of fixed coupon bonds must fluctuate to change the payable yield as interest rates and expectations change. That isn’t required here because the coupon itself fluctuates.

In my opinion it’s the extremely low BoE rate that has pulled the price of CEBB so far down as to give me the chance to buy – I hope – cheap.

A bet on higher interest rates

As I see it the price of these securities is determined by two factors:

  • Long-term interest rates (where Consols might be a proxy)
  • An ‘option’ on bank rates rising in the future

Given that the rate that CEBB and INVR pay is currently around what you get on Consols, the market doesn’t seem to me to be valuing the option very highly.

That said it does have some value. These bonds are both far, far riskier than UK government bonds like Consols. They should be paying a higher yield to reflect that risk. It’s the ‘option value’ that is bringing the rate payable down to 4%.

There is probably a formula out there in the quant world for valuing such securities, but I don’t have it.

However using my simplified and more conservative second price formula above (modified for CEBB), and assuming that the option value doesn’t change as rates rise (it probably will change, but I am not confident as to which direction, as it’s down to market psychology) then one can generate a table of potential prices at different rates like this:

BoE rate 0.5% 2% 3% 5% 8%
CEBB price (p) 75 82 85 88 91
INVR price (p) 375 545 615 706 783
CEBB gain n/a 9% 13% 18% 22%
INVR gain n/a 45% 64% 88% 109%

Note: Author’s guesstimates

Remember: These are not guaranteed returns or anything like it! They are just my best guess at how capital values might move if rates start to rise.

Credit risk and future returns

One big reason I know the smooth escalation in returns implied by my table will probably prove inaccurate is because I know that at the end of 2008, when the base rate was 2%, CEBB was around 100p, compared to the 82p predicted by my sums.

So what might we put that difference down to?

Some of it will be due to the different expectations for interest rates. Back then, a 2% rate seemed extremely low and unlikely to last – it was the historical low for the past 300 years. Now a 2% base rate seems almost outlandishly high.

Secondly, the market perceives much more credit risk around the likes of Nationwide and Investec than in 2008, let alone a few years before the crisis. I suspect that will persist for years.

The market is right to be warier than it was. Once upon a time, PIBS were touted as effectively risk-free for pensioners, widows and orphans, but in recent years all that has gone out of the window and some holders have been left bitterly disappointed. It will be a long time – if ever – before they recover their former status. There’s no guarantee that something terrible won’t happen beforehand.

However whereas credit risk is a very real danger with these two issues, I think interest rate risk from here is pretty modest.

Even if the Bank of England were to cut to 0%, the fixed elements of the coupons would provide some return. As a result I think the downside risk from further interest rate cuts is limited.

Float, float on

Do I think rates will shoot up to 2%, let alone 5%, anytime soon?

I don’t expect to see even 2% for a couple of years, but I do expect to see higher rates one day. The price of these securities probably won’t do much until then, but I can think of worse outcomes than getting paid 4% a year while I wait.

I haven’t gone crazy here due to the very real credit risk and the hideous spreads, but I have bought small tranches of both CEBB and INVR for my ISA.

Note: I am not a financial adviser nor am I a world authority on bonds. This is not personal financial advice. Please do your own research and make your own mind up about these illiquid, risky securities. I am not liable for anything – on your head be it! See my disclaimer.

  1. Permanent Interest Bearing Share []
  2. In normal times LIBOR is roughly the Bank of England base rate plus a small mark-up of about 0.15% []
  3. Note: This PIBS trades clean, which means you also have to pay for the interest accrued when you buy it. []
Filed under: Investing, Shares

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{ 32 comments… add one and remember nothing here is personal advice }
  • 1 ermine January 24, 2013, 10:26 am

    > but I do expect to see higher rates one day

    And when that happens, it happens fast while people aren’t watching or expecting it. I’ve paid 14% on a mortgage in the past! I took it out when the interest rate was half that.

    I haven’t got the cojones for this sort of action, but it sounds good – all the best!

  • 2 Simon January 24, 2013, 11:12 am

    Interesting indeed, thanks. How would one go about acquiring these securities? I’m fairly sure my broker doesn’t carry anything of the sort.

  • 3 K Salisbury January 24, 2013, 11:25 am

    Or you could look into something with much higher liquidity, like an ETF referencing floating rate bank debt (personal favourite is $BKLN). You get higher liquidity, and the better recovery rate of a diversified senior loan portfolio. Much less risk, also referencing Libor rates as an inflation hedge.

    Doesn’t work in a hyper-inflation scenario, but in many ways it’s like having a solid IR collar hedge on, where the range you expect is higher than the consensus. With some moderate price appreciation, I’ve done very well sitting on it for the past 6 months or so, and it lets me sleep easier in an age of QE Infinity.

  • 4 The Investor January 24, 2013, 11:39 am

    @K Salisbury — Yes, much less risky but I think without such upside potential. Likely a better option for most to get broad asset allocation like that of course.

    @Simon — Normal brokers do deal in them, at those horrific spreads. Please remember the article is not a recommendation and these are very risky compared to broad funds, as K reiterates above. At the risk of sounding patronising, if one is not used to dealing in illiquid small issues etc that’s twice the reason to steer clear! 🙂

  • 5 Neverland January 24, 2013, 1:22 pm

    Like you say in the article the 7-10% bid offer spread reduces the returns a lot – I think (mental arithmetic) to a similar level to index linked unless you are holding for more than 5 years

    But if you are holding for more than 5 years you are exposed to the underlying credit quality of the company issuing the bond

    Its maybe something to park 2-5% of your long term investment pot in, but that isn’t going to make much difference to most people if it outperforms

  • 6 mark January 24, 2013, 3:05 pm

    Interesting article,…. made even more interesting by the movement of both these instruments in the market this morning… one up 5% the other 4.5% !!!

  • 7 Simon January 24, 2013, 3:12 pm

    Thanks, TI. No plans to splurge as it stands, I was mainly just curious. It looks like they do handle them after all, they treat them like any other share whereas I had assumed they’d have a special category or something.

    Still, as I say, something that I’d need to learn a lot more about before diving in!

  • 8 The Investor January 24, 2013, 3:24 pm

    @Mark — These shares always *appear* to post moves like that — it’s just down to the huge bid/offer spread, not any actual volume usually in my experience.

  • 9 Moneyman January 24, 2013, 6:33 pm

    Very interesting post Investor. I think you’ve convinced me! Low current yield but nowhere to go but up.

    Now, just to find something to sell…

  • 10 Neverland January 24, 2013, 7:53 pm

    @ Moneyman

    “Low current yield but nowhere to go but up.”

    You could be waiting a long time for them to go up, interest rates in Japan have been nearly zero for 20 years and counting

  • 11 The Investor January 24, 2013, 8:03 pm

    But in that world you collect your 4%… 🙂 I am wary of credit risk but 0.5% for decades would not be a disaster for these bonds IMHO.

  • 12 The Investor January 25, 2013, 2:10 am

    @Moneyman — I’ll look out for your write up! You know your way around PIBS etc already of course so will be interesting to see how you feel they stack up.

  • 13 gadgetmind January 25, 2013, 10:19 am

    I’ve been watching INVR, CEBB and a few others for quite so time. However, those nosebleed spreads have been enough to keep me away to date.

    I have cash coming in April (courtesy of shiny new CGT allowances) and might try and find a grown up broker who can bag me some FRNs from my list.

  • 14 Dan January 25, 2013, 2:19 pm

    Interesting post, though in my view the risk/return profile just doesn’t match up. Looking at the risks, these securities are equity in all but name. They will qualify for the core capital ratios of the banks who issued them under Basel III and, in all the new regulations coming in, will be considered a first loss piece should the banks go belly up. You are therefore taking a large credit exposure to the relevant banks. A second risk which would worry me is their undated nature. In short, a perpetual cashflow becomes worthless in the long run (i.e. there is huge inflation risk). As such, these are best seen as a medium term investment. Are these risks priced in? Given the comparison you made to consols (a zero spread v. government debt for a first loss piece in a bank) it doesn’t look like it. This isn’t to say that they don’t have a place in a diversified portfolio – but on their own they look very much like a punt on interest rates rising in the 3-7 year horizon (by 10 years the value of the perpetual cash flow could have shrunk in real terms by as much as 1/3, pretty much cancelling any significant gains from changes in interest rates).

  • 15 The Investor January 26, 2013, 10:41 am

    @Dan — Good analysis and counterargument. I don’t disagree with much of what you’ve written except that I think it’s a little “glass half full”. 🙂

    Pepetuals are an established asset that people buy, as you know. It’s not just these two securities. My point is they are considered to have a role, by and for some people.

    You’ve said that in 10 years the value would have shrunk in real terms by 1/3, but remember that (in theory) you could be reinvesting the income stream they through off back into them throughout, which would increase it by 45-50% in nominal terms by 2022 (assuming no change in rates). That’s going to be ahead of BoE target inflation (assuming they hit it! 🙂 )

    In practice the insane spread here might make reinvestment unrealistic or ill-advised, but it doesn’t negate the value of the income stream. (You could reinvest into something else and maintain your spending power that way).

    I agree with you that perpetuals are pretty unattractive most of the time, and surely especially when rates are low — I wish I’d bought Consols yielding 12% a couple of decades ago, but you’d be nuts to buy them today yielding 4% in my view.

    However these have the floating rate element, as much discussed above, which means as far as I can see, absent credit risk, you’re extremely likely to see a very large capital gain at some point in the next 3-20 years. (And I suspect we won’t wait 20 years, personally).

    I think this capital gain will be more than enough to offset the spread, particularly in the case of INVR. A move to even 1% rates should see them rise to 445p. The table above (conservative in my view) shows the potential rewards beyond that for INVR. (For CEBB it isn’t so clear cut, except I think the prices are perhaps irrationally low currently, so might bounce back in a better climate as the fear factor is resolved. They were 100p when rates were 2% in late 2008).

    On that final note, credit risk is very real — but plenty of people buy other PIBS and preference shares from banks and building societies. The former were a much-touted asset class for widows and orphans at one point (incorrectly in my view). I think that was complacent, but the pendulum did swing too far the other way I feel.

    Re: Bank recaps, failure would be bad (though even then I think CEBB *might* get you something) but you are a step above equity if there’s a partial cash infusion (e.g. a rights issue) which I am betting is more likely at this juncture. (Touch wood! 🙂 )

    Absolutely agree with your point on position size. I have around 3% of my portfolio invested between INVR and CEBB (a bit more in the former than the latter).

    Thanks again for the counterpoints!

  • 16 Niklas Smith February 14, 2013, 7:02 pm

    “Investec is more diversified, but much of that is diversification is in South Africa. That is a bit like diversifying a hot burn you’re getting from holding a frying pan by sticking your free hand into the fire.”

    That short paragraph deserves to become a classic, I think 🙂

    Regarding floating interest alternatives to savings accounts, are there such things as money market funds in the UK and how do they perform after fees? In Sweden there are some that give reliably higher interest than most bank accounts thanks to ultra-low fees (the lowest charges 0.1%) and good asset allocation (interestingly, that same cheapest fund has a fairly large chunk of its assets in floating rate notes from investment grade Swedish companies and banks).

    Given the credit risk involved it would seem sensible to diversify through a fund, providing the fee does not eat your free lunch!

  • 17 Michael Reynolds June 10, 2013, 1:52 am

    In addition to the prohibitives spreads on CEBB & INVR what about stamp duty? CEBB is a PIB and therefore not subject to stamp duty but INVR is a preference share and would be hit?

  • 18 The Investor June 10, 2013, 9:14 am

    @Michael — Correct, you pay stamp duty when you buy INVR. The spreads are ridiculous, no two ways about it. The only thing one can do if minded to destroy cash by buying a few is buy when someone is selling nobody wants them to get inside the spread, and then sit tight for years and hope they don’t blow up in the way the Co-Op’s PIBS have recently. 😉

  • 19 Michael Reynolds June 10, 2013, 9:42 am

    I liked your article alot and believe it well thought out. A few months ago I also downloaded the Bank of England monthly rates since Aug 53 (my birth month) and worked out the average rate for my lifetime (60 years) and also the last 25 years which is the max I expect to live (85). Instinctively I just knew what the rate would be for my lifetime! It turned out to be 7.1% versus the 7% I envisaged. The rate for the last 25 years is 5.8%. The expectation for my portfolio is therefore 5.8% – 7%. Anything more is bunce.

    The only real trouble for me with INVR & CEBB is the spreads. 7.5% plus 0.5% stamp duty for INVR currently and 10% currently CEBB if available through Canaccord Genuity. I took a punt on Skipton 6.875% PIB last week and paid 79. The spread was a reasonable 1.95%. They are callable in April 2017 the best part of four years ahead by which time I’m hopeful that the rate will back around the 3% mark.

    We’ll see!

  • 20 The Investor June 10, 2013, 11:03 am

    @Michael — Yes, the spreads are the hurdle, and perhaps the opportunity (if it’s keeping others out of the ‘optionality’ built into these floating rate bonds). Certainly if rates get back to 3% then INVR in particular should motor past the spreads.

    I only hold about 2% of my net worth in these securities, and I actually reduced INVR a little when the price ran up a tad when it looked like the economy was improving faster than people expected (and Mark Carney hadn’t been appointed to the top job at the BoE). It was interesting how quickly they moved on even a glimmer of a hope for rates.

    At some point we will very very likely be “closer to the end then the beginning” in the Churchill sense for rates, and these instruments could become very attractive at that point.

    Also remember of course credit risk. Investec is very exposed to troubled South Africa, and I know some people think Nationwide is a Co-Op waiting to happen.

    All just for info, of course we all must make our own decisions and weight up risk and reward for ourselves. Best of luck with your own investments!

  • 21 Michael Reynolds June 10, 2013, 11:39 am

    Yes I wonder why the Investec spread is so high? Nationwide is a different matter. As you say they were lumbered with it when they acquired the Cheshire and it certainly doesn’t fit the business model they have applied to the rest of their PIBS. Oddly enough when it comes to the credit risk I have more reservations about Investec than Nationwide. They are far and away the largest BS in the country and they survived the GFC relatively unscathed. I can’t see any government letting them go under? Any thoughts on Santander? Good luck

  • 22 The Investor June 10, 2013, 12:13 pm

    The spreads are to do with the complete lack of liquidity I think Michael. Whoever is making a market in these doesn’t want to risk having to hold them, and as there’s basically no volume they are presumably demanding a big margin of safety for doing so and/or for enticing buyers/sellers out of the woodwork. Re: Nationwide, my strategy is simply to diversify across banks/building socs, I don’t believe I have any special knowledge into their affairs. Re: Santander, I don’t own any prefs but I do own the common stock, listed in Madrid, at roughly breakeven on today’s price. Risky but potentially hugely rewarding on a five-year view. Time will tell!

  • 23 Michael June 27, 2013, 8:11 am

    I just wondered what you thought about the huge price reductions/jump in yields on PIBS that have occured in the last couple of weeks. I can’t say it makes alot of sense to me? I understand the jump in Bond yields but this seems to have effected all fixed income yields? CEBB at 70 does look attractive but of course there has been this latest scare about Nationwide’s capital being short 2bn GBP?

  • 24 The Investor June 27, 2013, 10:40 am

    @Michael — I think it’s mainly a reaction to the Co-Op restructuring here in the UK, plus some additional downside from the rise in the risk-free rate from ten-year gilts.

    These haven’t been the greatest investment for me. I got lucky on the one I overweighted (INVR) and sold when the price spiked to around 400p when a rise in BOE interest rates sooner rather than later looked feasible, but I sold the others for a wash. I sold CEBB for a meaningful loss (more than 10% from memory, not counting income) but I wanted out for now (partly due to greater fears around Building Societies, partly because Carney seems even less likely to raise rates than King, and partly because I wanted the money for a value-investment opportunity).

    This wasn’t what I’d planned to do — I’d planned to buy and hold as some long-tail insurance, so not my greatest ever trade!

    I’d look to get back into CEBB and INVR, but I’d definitely want to see Nationwide get all its funding sorted out first. The Co-Op fuss has been particularly interesting for two reasons (a) the Co-Op doesn’t seem to care about the negative publicity and (b) the new PRA regulator hasn’t worried about wielding a bigger stick. Add to that the capital shortfalls identified at Co-Op and Nationwide, the latter due to a very questionable way of reading its riskiness, and the sector isn’t what it was a year ago.

    I do still hold some BOI prefs — I sold some of my holding a bit higher (but at a loss) but bought again recently at lower levels. This bank has already been through the wringer, and looks well capitalised (relatively speaking). I think I could double my money (on a total return basis) on these over 5 years in a recovering economy situation, though anything could happen clearly if we turned south in a big way again. I also hold a very tiny amount of Co-Op prefs (bought £1K, and they fell 20%!) bought on a punt that the Co-Op wouldn’t want to lose face.

    Away from fixed income I hold plenty of banking exposure via equities that I tend to trade around.

    All just my two cents — it’s been a very fluid situation with these securities and while I don’t think I’ve played it well, I don’t know that many people have to be honest.

  • 25 dearieme January 24, 2014, 12:04 pm

    Wouldn’t it be easier to hedge against rising rates by buying futures, or options, or other things I know nothing about?

  • 26 Tyro January 24, 2014, 1:09 pm

    Does anyone have any views about the advisability of hanging on to LLPC and NWBD as long-term holds? Obviously they will suffer somewhat in the medium term (say, 3-10 years) as base rate rises loom and then arrive, but might there be good reasons nonetheless to hold them on a 25-35 year view?

  • 27 Paul Claireaux January 24, 2014, 1:33 pm

    Yes at some point rates are going to nudge higher – though I’m not sure it will be for a while. Markets are getting spooked by all sorts of noise ATM (for example, from Davos about Islands in dispute between China and Japan) and around disappointing company earnings.
    I would have thought DEflation is back on the risk agenda.
    Either way – after an incredibly racy year in markets in 2013 it looks like 2014 is going to give us a reality check.


  • 28 The Investor January 24, 2014, 7:38 pm

    @dearieme — Think you’ve rather answered your own question there! 😉

    I think these instruments are pretty attractive and straightforward, with the enormous caveat of the spread (though for anyone who bought and held last January that’d already be history…)

    In fact if it wasn’t for the spread I’d argue they’d be almost a no-brainer as part of diversified actively invested portfolio. (The credit risk will always mean they should only be a small holding, of course, although I imagine many people are much more fearful of these than say holding the equivalent in an individual company’s shares, yet the risk here “should” be much lower).

    I intend (we’ll see) to just sit on them. I suspect the past few years has been a very unusual period of dislocation, and eventually CEBB will trade around £1 and INVR around £9-10, with the coupon simply adjusting to rates. We’ll see.

    @Tyro — In general perpetuals are tricky instruments to hold because the longer you go out the more you’re subject to inflation risk (plus you’re continually rolling the dice on credit risk! 😉 ). If we had a five-year period of say 5-10% inflation, your tranche of perpetuals are going to be toast in real terms, and there’s no redemption date / price to help you out.

    In contrast, equities, say, can better keep their value as their earnings and dividends are not fixed and so can (eventually) respond to inflation.

    On the other hand, long / perpetual duration is great for protecting against deflation. If we really did become “the next Japan” and assuming Lloyds/Natwest didn’t get into difficulties, the price of those fixed interest perpetual preference shares would likely soar. (I still have a small amount in LLPC by the way, and rather more BOI).

    @Paul — Well that’s why you diversify. Deflation is easily hedged against via those government bonds you hate or even cash. Inflation can be hedged via equities among other things, but these chaps should do much better than equities in a stagflationary sort of environment, assuming the Central Bank is trying to fight the inflation via higher rates rather than just allowing it to happen (perhaps a big “if”).

    As a 1-3% position in a diversified portfolio, they do something different, and that’s likely very valuable to all but those who claim to be able to pick which asset is going to do well and which poorly in each 6-12 month period.

  • 29 Grand January 25, 2014, 12:53 am

    Wow what a topic!

  • 30 Greg January 26, 2014, 9:41 pm

    Why not get the diversification of a floating rate investment trust and avoid the main pitfalls mentioned?

    e.g. the following ITs:
    NB Global Floating Rate Income Fund (NBLS)
    Alcentra European Floating Rate Income (AEFS)

    The following aren’t pure plays but have a big chunk in floating rate notes:
    Henderson Diversified Income Limited (HDIV)
    TwentyFour Income (TFIF)

    I have my eye on all of them. Note that they cannot be thought to be a replacement for Gilts as they are not high quality debt!

  • 31 The Investor January 27, 2014, 12:37 pm

    @Greg — Yes, worth consideration, thanks for the reminder. Of course as investment trusts they do introduce discount risk. First that you overpay (AEFS is on a slight premium currently, for instance) but more importantly that if they sell-off hard in a risk-off bear market scenario, you might get extra downside beyond the interest rate / credit risk response you’d expect to see reflected in the coupon/capital. Though the latter is true of CEBB and INVR, too, since they’re so illiquid.

    Plus currency risk of course, and management risk and fees. On the other hand massive diversification benefits.

    AEFS seems an attractive and sensible alternative (haven’t looked properly at the others) especially now the price of INVR especially has moved up so much since January 2013. Though arguably both it and CEBB have some extra ‘special situation’ upside to them.

  • 32 CKP March 14, 2014, 1:48 am

    I’ve held a substantial amount of CEBB for a few years, buying in shortly after QE. At the time I didn’t think rates would stay depressed for so long. I also bet that it was unlikely that NWBS would risk reputational damage by defaulting on such a tiny PIBS issue. I read the Cheshire BS PIBS prospectus and the conditions for non payment were vague. It has become clear more recently that PIBS are no longer seen as tier 1 loss absorbing capital and so may have a better credit status than previously thought. I have long regarded CEBB as my hedge against rising rates adversely affecting my equities portfolio although a repeat of 2008 would sink everything again. I have also recently bought some INVR but these seem to be in demand. My other hedge holding is RBPX which is a senior RBS credit paying 1.5xRPI. Made some nice gains from my fixed coupon PIBS and prefs but clearly these will head South when rates rise so I have started selling them off. But with many smaller PIBS issues the huge spread makes them buy and hold investments, I was fortunate to get some at 9-10% yield on cost and unless inflation really takes off it doesn’t make sense to sell.

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