I admit it: I’m a capitalist. I believe in free markets. I think the invisible hand can do more than pick pockets and grope hard-pressed students packed onto the privatised railways.

Greed can be good – if it makes companies more efficient and brings more of us the products and services we want at lower prices.

Outrageous? Before you lynch me, you’d better know I’m not the only one.

We capitalists aren’t horned beasts dancing around pyres of sub-prime mortgage certificates. We’re men and women of all shapes, races, and ages. We have places where we get together, where we whisper to each other interesting business opportunities and swap tips on investing our SIPPs.

But these days we’re scared to be out and proud.

What a shame! We live in a capitalist world, and it’s only by living as capitalists that we can truly make the best of it. Capitalism isn’t just for golf club swingers and septuagenarians in South Kensington. It’s the system we all work within.

Unless you’re a dropout living in a tree tent above an anti-fracking campsite, you need to know the rules of the game to thrive. Taking a half-hearted approach to capitalism is like a goldfish taking a half-hearted approach to swimming.

You have to be in it to win it.

This is especially true as one of the least cuddly aspects of capitalism is it helps best those who help themselves.

The quickest way for the 1% to become the 0.1% is for the rest of us not to play the game.

With that in mind, here are 11 tips on how to be a capitalist.

1. Get some capital

Clues in the name. To be a capitalist you need capital. You can then invest this money to make more money, and be on your way to mega-riches. (Dust down your old Monopoly board if you’ve forgotten how it works).

I think one of the great strengths of capitalism is that it’s theoretically open to anyone. Rival systems claim to be more fair, but invariably they boil down to who you know (Marxism), who your parents were (feudalism), or who you were prepared to shoot in the head (dictator-ship-ism).

Most human beings will try to get ahead. Capitalism harnesses this, rather than fancifully suppressing it only to see it come out in less useful forms.

So, how do you get your capital?

Obviously it helps to be born to a rich capitalist1. But most of us will need to spend less than we earn.

That difference is your seed corn. Saved and invested, it will be the start of your capitalist empire.

2. Own the means of production

Here’s what Karl Marx knew and you should, too:

“In capitalist countries, the rulers own the means of production and employ workers. Means of production are what it takes to produce goods.

Raw materials, machinery, ships, and factories are examples.

“Workers own nothing but their ability to sell their labor for a wage.”

If you want to thrive in a capitalist economy, you need to follow Uncle Karl’s advice and get yourself some factories, machinery and ships. Or rather their modern equivalents, like data centres, luxury retailers, and offshore oil drillers.

If you don’t own the means of production, then all you’re doing is selling your labour for a wage.

That is, you’re a wage slave.

Happily capitalism has come a long way since Marx’s time and it’s now easier than ever to get your share of the money-minting machines.

By putting your money into a stock market tracker fund, you’ll buy a slice of all the major listed companies in the country – or even the world, depending on which fund you buy.

These tracker funds are cheap to own, and enable you to leave your company managers to get on with making profits. As they do so, the companies will become more valuable, and the value of your holdings will rise.

By reinvesting the profits they pay out as dividends, you can buy more slices of the companies, too. Over time it’s reasonable to expect 5-8% growth a year in today’s money terms from your basket of global companies.

3. Own other assets, too

Owning a slice of the productive economy is key to getting your stake in the capitalist system, but companies are not the only assets to amass.

Other potential things to buy are rental properties, fixed income investments like bonds (where you’re basically making a loan to a company), and of course you want to keep some cash handy for future corporate raiding (a.k.a. buying into the stock market when it’s cheap).

You might even consider making loans to spendthrift wage slaves via Zopa, which now has a Safeguard in place that should protect you from bad debts.

The key is to have more income producing assets than money-sucking liabilities.

Some argue that our economy sneakily tries to turn even high-earners into indebted consumers. That way they stay on the treadmill of working and spending, enabling those at the top to stay rich.

I won’t get into the conspiracy theories here. But whether that theory is right or wrong, by refusing to play the consumption game and choosing to own assets instead, you’re closer to the top of the pile than the bottom.

4. Treat yourself as a company

Who is the archetypal capitalist – Bill Gates or Richard Branson?

For me Branson wins that matchup every time.

Gates may be richer, and with Microsoft he built a far bigger and more world-altering business than Branson ever did.

But Sir Richard is the consummate entrepreneur. He’s restless and forever shuffling his cards, always looking for how to best spend the next year and the next dollar to greatest effect.

Branson understood early the power of personal branding, especially in a nation of shrinking violets. And on a personal level, he doesn’t get hung up on what he can’t do (he’s dyslexic, for example) but rather on what he can.

Virgin is Branson, and his business activities are an extension of his ambition and of his curiosity about the world. It’s as far from the wage slave mentality as you can imagine.

Like Branson, you can treat yourself as a company, too.

What are your strengths? Where can you deploy your talents to earn the highest return? What assets are you not using, and where are you wasting money? Did you over-invest in a university education and under-invest in networking? Did you skip classes in the school of hard knocks?

What does your personal profit and loss statement and your balance sheet look like?

Not everyone needs to start a business or turn into an entrepreneur.

But to thrive in a capitalist world, it pays to sometimes think like one.

5. Turn yourself into a company

That said, it’s actually not a bad idea to become a company if you can.

I don’t mean you need to give up being a doctor or a programmer or whatever you are, in order to launch a rival to McDonalds.

But if you can you do your job as an independent, one-man band – a freelancer or consultant or small business owner – then there are plenty of advantages:

• You’re in control of your time and your productivity.

• With a diversity of clients (at least two!) you’re less exposed to the cost cutting measures of your capitalistic taskmasters. (i.e. Getting fired.)

• You’re usually taxed more attractively.

• It’s easier to put large amounts of money into a personal pension.

• No more idiotic office politics.

• If you invent something, you’ve a better chance of owning and exploiting it.2

There are some disadvantages, of course.

When you run the show you can’t slack off, and the freelance and consultant budget can be the first to get chopped in hard times. Put money aside in case.

There’s also more paperwork, and you may need an accountant.

In many countries you’ll need to budget for healthcare, too, although in the UK we have the NHS to show for our taxes – a boon that’s often underestimated by UK entrepreneurs.

The next step beyond being a one-person show – running a proper, expanding business – is obviously gold stars and top marks when it comes to being a capitalist. Instead of making someone else rich, you have people making you rich.

Marx would say you’ve turned the tables. Now it’s you exploiting labour for your own profit – which is a result for our purposes.

Besides, there’s nothing to stop you implementing profit sharing or other enlightened benefits should you want to be a conscious capitalist.

It’s hard to start a business – much harder than some pundits with books to sell will tell you – and it’s risky.

I think becoming a self-employed problem solver is a good halfway house.

6. Create multiple income streams

Another baby step towards being the J. D. Rockefeller of your neighbourhood is to look for ways to add to your primary income.

Can you teach a musical instrument or a language, or some other skill? Could you invest in a franchise alongside an ambitious niece or nephew? Do you have expertise that would enable you to trade antiques for a profit? Could you write and publish your own digital books?

The list is very long, and your hours will be longer than Joe 9-5, too, so try to pick something you enjoy.

The benefits of adding extra income streams are you diversify your earnings, you can save and so invest more, and you think of yourself even less as someone with a job, and more as an entrepreneur. Mental beliefs are an important part of the picture here.

Don’t dismiss the value of even small amounts of extra income. Any additional passive income streams are valuable when you think of all the capital it would take to earn the same return in a low-interest rate world.

7. Diversify, diversify, diversify

Capitalists know the world is changing fast. Rather than moaning about it, they look for opportunities.

If you can address a strong need someone has, then they’ll pay you for it. Over time we get most of our new gadgets, services, and vices like this.

But that same rapid change that capitalism thrives on – and indeed fuels – is also a threat.

Sentimentalists think we should still be making all our own cars, washing machines, and aeroplanes in factories in each individual country.

Capitalists know global trade has (rightly) ended all that, but they also understand it could be their business that is “creatively destroyed” next.

Rather than hope that laws and regulations can protect your industry – let alone assuming you’ll have a job for life – it makes sense to diversify your skills, knowledge, investments, and other assets.

Be ready for total upheaval, because the chances are it will come at least once in your lifetime.

Getting the right balance is tricky, because capitalism rewards specialists – up to a point. They are more efficient, productive, and usually do a better job. But that also makes them expensive, which increases the chances they’ll one day be replaced by a robot, or cheaper talent in India.

I’ve personally tried to be a generalist for this reason. The alternative is to keep on the cutting-edge of your speciality, to stay young-minded, and to continually seek education and new opportunities.

Don’t fight inevitable change. Just ask the old music label bosses undone by digital file sharing, the engineers replaced by Japanese assembly lines, the IT managers whose jobs have been lost to The Cloud, and so on and on and on.

As for assets, old money diversifies, spreading its wealth. Many new rich people keep it all in one or two assets and either become a lot richer, or go bust.

8. Become an expert asset allocator

One huge reason capitalism works is because it harnesses millions of people’s individual decisions about where to put their capital and effort to best use, as well as what to spend it on.

In communist Russia, comrade Igor and factory chairman Alexander had to decide how many tractors the company would produce in five years. They’d consult with higher-ups in the party and local farmers, and be told there wasn’t enough steel anyway because some other comrade who ran the steel plant was pessimistic and had turned to drink.

These people were just as smart as us, but the system was stupid. They didn’t have the information required to best allocate their resources.

Capitalism replaces all this guesswork and centralised control with prices, which reflect supply and demand. Capital flows to the places where it has the best chance of multiplying, for a given level of risk. Prices of goods and assets change to reflect this.

The system is far from perfect. Despite what academics need to believe to make the sums work, none of us is ultra rationale. Amongst many other things, we get greedy, we get fearful, and we don’t always have perfect information.

As a result, capitalist economies have booms and busts.

Sometimes certain assets and opportunities are too expensive, while others are a steal. Capitalists can make mistakes at knowing which is which, just like two comrades could disagree on the national cabbage target for 1956.

Your job as a capitalist is to try to do a better job at telling the difference between cheap and expensive opportunities. You want your money – your capital – to be in attractive and sustainable places, and you want to pull some or all of it out of areas that look too frothy or, conversely, look doomed.

You don’t want to invest in flaky stocks at the height of the dotcom bubble, but equally you don’t want to retrain as a horseshoe fitter the year before Ford takes motor cars mass market.

Try to be alert to the relative attractions of cash, bonds, shares, overseas markets, and the other assets you invest in.

This is easier said then done, and many investors find they’re better off adopting a passive approach to their portfolio, periodically rebalancing to ensure they don’t become too exposed to fads. This method automatically puts money to work in the unloved – and under-priced – opportunities.3

There are allocation decisions to make outside of your share portfolio, too.

Stuck in a country lane for two hours on a Friday night? Maybe it’s time to sell your holiday home. A third person asks if they can buy your antique Aston Martin? Perhaps you should sell it. Can’t sell your Spanish buy-to-let for love nor money, despite deep price cuts? Maybe you should be a buyer, not a seller.

You might not want to sell granddad’s medals from the war (I’m always amazed by how people on the Antiques Roadshow will swap precious heirlooms for two weeks somewhere sunny) but otherwise, all your assets should have a price where you’d sell.

And a price where you’d buy back in!

9. Be flexible

Be open-minded. Money doesn’t care where it’s put to work, and nor does a capitalist, beyond legal considerations and your own ethics.

How many people have daydreamed about opening a cool coffee shop? Countless – there are even books on it. I’d suggest there are probably less over-supplied areas to look towards if you want to get into retail or restaurants. Think creatively.

Workers tend to pigeonhole themselves, whereas capitalists are business people first and foremost. Richard Branson is again the supreme example – he’s not just the record shop guy, the airplane guy, the fizzy drink guy, or the financial services guy – he’s all of that and more.

Stay alert to opportunities. They come up in strange places.

As a freelance I earn most of my money from something that began as a hobby when I was doing something else, and I have various other income streams that deliver the same again from assets I own.

I’m not Richard Branson. But I am a capitalist.

10. Minimise your taxes

Capitalists believe that free markets – and companies and consumers expressing their choices and voting with their wallets – deliver the most productive allocation of humanity’s resources.

That’s not to say markets necessarily deliver the “best” allocation, because the word “best” is so subjective.

I’d personally prefer half the money spent on cheap clothes in Primark went on conserving the world’s rainforests, for example, but few shoppers would agree.

What if 90% of people in the world got 100% richer but 10% got 50% poorer – would that be good or bad?

If you were one of the unlucky 10%, you’d probably think it was bad.

What if that 10% wasn’t at the bottom of the pile, but rather they were the richest? Is your answer different now?

This sort of conundrum – invariably combined with self-interest – is why even close friends rarely entirely agree about politics and economics.

I have dear friends who will find this whole post horrendous! The fact is though that I believe the private sector will deliver better outcomes in most cases. Even for some thorny issues. In my ideal world, beyond a safety net for all citizens, government is mainly about setting the rules for society to get the results the majority want.

Cleaner lakes and rivers? Less fat cats in the boardrooms? More houses? Fewer people dying of heart attacks? The State doesn’t need to make that happen through the public sector. Change the rules and set the right incentives, and smart entrepreneurs will find a way.4

The logical conclusion is that a capitalist believes she knows better how to spend her money than the State does. Money is better off in our hands.

It’s a legal requirement to pay your share of the taxes, and I’m not suggesting otherwise. But there’s a big difference between tax evasion and tax avoidance.

A capitalist doesn’t donate money to the public purse – not when he or she believes it’s better being put to work by hungry entrepreneurs and companies. I don’t believe in a zero-sized public sector, but with the government already taking more than 40% of the UK’s GDP, I think it’s got enough to be getting on with.

Besides, if you’re taking the risks, why should the State take a big slug of the rewards?

Always take into account capital gains tax and taxes on income. Paying high taxes on your investments makes a big difference over the long term.

11. Give something back

My comments about taxes may have riled some readers, but I’m not praising personal gluttony and excessive hedonism.

I’ve not once mentioned driving sports cars, bathing in the milk of alpacas, or guzzling expensive champagne with high-class strippers (whether Wall Street asset strippers or the more traditional variety).

Although who wouldn’t want some that now and again? Perhaps not all the same time.

Whatever, it’s a personal choice that has nothing to do with capitalism. Many communist and socialist legends could spend money with the best of them on the backs of the workers. Plenty of capitalists have been wildly greedy, but Bill Gates has devoted the rest of his life and fortune to philanthropy, and Rockefeller didn’t drink or smoke.

Nobody succeeds in a vacuum. A healthy, educated population, family and friends, infrastructure, and the rule of law – none of this comes cheap. That’s why I’m happy to pay a fair share of taxes, and why I think it’s good to give something beyond that to causes that are meaningful to you.

Plus it feels good to spend your money helping others.

Some of the greatest modern mega-capitalists including Gates, Warren Buffett, and Mark Zuckerberg have pledged to give away at least 50% of their fortunes to philanthropy. Others work behind the scenes – and yes, a few inevitably want their names above the wing of a hospital or library.

Who or what would you like to help if you were wealthy?

Thinking about it might just help you get there.

1. Because I believe in equal opportunity I’d support higher inheritance taxes, unlike my supposedly socialist friends who bemoan the taxes the State will claim when their parents in the Cotswolds conk out [↩]
2. Check your contract. Many terms of employment stipulate your employer owns everything commercial you think up – even if it’s unrelated to your day job! [↩]
3. Passive investing is the ultimate way to trust in the wisdom of the market, making passive investors uber-capitalists, whether they like it or not! [↩]
4. Don’t blame capitalism that we don’t have a perfect and fair world. The fact is people don’t vote for a lot of things that would be better for everyone in the long run. [↩]

Good reads from around the Web.

Investing can be very simple, provided you don’t want to beat the market. Since most people will fail to do that anyway, the conclusion is that investing should be simple for nearly everyone.

Once upon a time that was okay in theory but difficult to put into practice. Between you and simple investing stood the Financial Services Industry with its expensive funds and obfuscating flak, and its foot-soldiers – the legions of badly-named Independent Financial Advisers, who would have been better named the In-It For Themselves Advisers.

At their worst they were swindlers and leeches.

A lot has changed in recent years for the better. RDR has done away with much of the hidden costs of investment. Monevator readers may be aghast when their annual expenses go up by 0.3% a year, but that pales besides the 5% upfront fees and 2% annual commission my father’s generation paid.

Savvy readers are already exploiting simple passive allocation strategies and cheap index trackers to make their money stretch farther.

The ubiquity of such cheap funds – plus far more education about them, usually online – has been the other great change in the landscape.

Even a schoolkid can do it

Some are still skeptical about simple investing. Particularly if they have complicated investing products to sell.

Such people should read the always excellent Allan Roth, this time writing at Index Universe, where he details the 10-year performance of his “Second Grader” portfolio.

This mixes just three index funds – at its most aggressive some 60% in US equities with 30% international equities, and a 10% bond allocation.

Was this the perfect allocation?

No, but you won’t get that either.

Was it the highest returning?

No, don’t know what was, and for our purposes here I don’t care.

The point of such as strategy is not perfection. It’s simplicity and ease, and the fact that it works. And that’s all most people need.

UK investors should have more in international stocks and less in our home market because it’s so much smaller than the US, but aside from that there’s no reason you couldn’t repeat the trick here, and then go off and learn the violin or read the complete works of Proust or do something else with all the time – and money – you’ve saved.

Why does simple brilliance work, Roth asks?

First, it has the lowest costs, and we all know costs matter.

Second, it uses the broadest index funds. Research demonstrates that narrow index funds have larger gaps between fund and investor returns—geometric versus dollar-weighted—than broad funds. That’s to say we do more performance chasing on narrow funds than broad funds.Again, the conclusion is that broader is better.

Third, rebalancing resulted in investor returns exceeding the funds’ returns. While simple, it’s not easy to ignore the media, which usually predict the continuation of the past.

Wise words, but don’t ignore Monevator when you go on your media diet, I beg you!

[continue reading…]

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:

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:

(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 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. [↩]