‘Hybrid’ bond income called into question

How far up the risk pyramid are you prepared to go, to earn a decent income on your capital?

At the bottom of the risk pyramid are conventional corporate bonds issued by banks. They are deemed “senior” debt – which means that, if all hell breaks loose, their holders are first in line to grab the assets. This is something of a generalisation – not all bonds are created equal – but the deal is the same: they offer a decent yield in return for taking some risk on the solvency of the institution.

At the top of the pyramid are shares, which are basically worth whatever one believes the total reserves to be, give or take any bad debts, any cash left over after paying the dividend (assuming there is one) and large sums in bonuses (!). In many cases, the value ascribed here is next to zero.

Somewhere in the middle sit the hybrid securities: permanent-interest bearing shares (Pibs), if issued by a building society; perpetual subordinated bonds (PSBs) if issued by an ex-building society that is now privately owned (usually by its rescuing bank) or preference shares/contingent convertibles (Cocos) if issued by a publicly listed bank.

”Contingent” means that the issuer can basically do anything they want with them – unlike senior bonds where they must pay the fixed interest “coupon” to stay solvent. So the banks stopped paying coupons on their preference stocks, prompting a big sell off.

Coupons have still been paid on virtually all Pibs and PSBs – but, in recent months, a new scare has prompted another sell-off: the risk that the issuing bank or society does not honour its gentleman’s agreement to “call” these bonds and pay investors back.

In the past, investors had a nice coffee with the senior brass at t’Northern building society – and left the room thinking that the call would happen. But the regulator doesn’t like these verbal understandings. It takes the view that calls are optional and risky hybrid capital should be – not to put too fine a point on it – risky.

Last July, Principality Building Society finally broke the silence on this issue and announced it wasn’t calling its 5.375 per cent PSBs, and was lowering the coupon to three-month Libor plus 105 basis points – equal to about 2.15 per cent.

Over the next few years, many more PSBs and Pibs are due to be called, but I reckon many issuers will take the regulator’s argument and switch their coupons to a much lower rate. Then again, maybe the more robust building societies might choose to salvage the integrity of the Pibs market and stick to the gentleman’s agreement.

Either way, the last thing the hybrid securities market needs right now is more uncertainty. Banking prefs specifically – and hybrids generally – have been hit hard by investors worrying about systematic financial risk. Many large institutions abandoned this market, leaving it to discretionary managers and private investors. That stymied volumes – which had the inevitable effect of widening the spread between buying and selling prices.

Meanwhile, the growth of the order book for retail bonds on the London Stock Exchange has prompted many investors to turn elsewhere for a yield. Just last week, social housing group People for Places launched a new bond with an inflation-linked 1 per cent coupon.

Add it all up, and it results in volatility in the price of Pibs. According to a recent note from Collins Stewart, Nationwide has some Pibs due to be called in February 2013 which could either be redeemed at par value of 100p (the mid-price is currently 65p) or passed, in which case the price could fall as low as 27p.

Collins Stewart has sensibly decided to model what could happen to prices if a range of bonds and securities are not called over the next few years. Admittedly, their model is informed guesswork, but it does show potential for big falls. They could exceed 20 per cent in the case of the hybrids issued by: Co-operative Bank, 5.55 per cent coupon; One Savings Bank, 6.591 per cent; Coventry Building Society 6.092 per cent, Nationwide 6 per cent and Skipton 6.87 per cent.

Even so, that has not stopped some intrepid, adventurous souls from starting to wade into this market, tempted by all the uncertainty and a wider sense of unease in the financial system.

adventurous@ft.com