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 [1] 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 [2] 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 [3] 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 [4] 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 [5] Merryn Somerset-Webb:
[6]
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 [7]:
[8]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 [9] 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 [10] (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 [11] 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 [12]. 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 [13] 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 [14] 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 [15] + 2.4%
Duration: Undated
Bid/Offer: 70/77p3 [16]
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 [17] 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:
(Coupon/price)
= (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 [18] 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 [4].