Bradford & Bingley (B&B) made British banking history this week.
It became the first issuer ever to defer interest payments on its permanent interest-bearing bonds (Pibs). Issued while B&B was still a building society, about 1,600 retail investors hold the bonds, which were converted into ‘perpetual subordinated bonds’ (PSBs) when B&B demutualised. The group has now warned it won’t pay the interest due on these PSBs on 20 July; the next payment – due in October – is under threat too.
What are Pibs and PSBs?
Pibs and PSBs are effectively IOUs, behaving just like most other bonds. They typically carry a fixed coupon paid in two semi-annual instalments. The price is set by supply and demand.
The first thing for a buyer to watch is interest rates. As the base rate falls, bond prices normally rise, as the fixed interest payment becomes more valuable to an investor.
The second issue is default, or non-payment, risk. As this risk rises, prices fall, driving up the quoted yield (the expected return as a percentage of the current price). On this basis, it’s clear the B&B decision comes as no real surprise – around six months ago, the B&B yield was around 50%, showing that few investors believed the payment would actually be made.
The bad news for holders of the B&B debt is that the government is under no obligation ever to repay a penny of the invested capital. The bonds in question are permanent, which means there’s no fixed date at which the issuer needs to repay the debt. Instead, investors have to try and sell in the open market.
But with the prospects of receiving any future payment at all rather cloudy, no one wants to buy them, which means prices are low and the typical gap between the buying and selling price – the spread – is wide. The Daily Telegraph, for example, cites one investor who bought £18,000 of B&B Pibs in 1998 and now reckons his holding is worth around £3,100 – assuming anyone will buy it.
So are any bank bonds worth buying?
When we wrote about Pibs in December (issue 416), we warned investors to avoid the B&B bonds. And as Simon Adamson of CreditInsight tells Bloomberg, the B&B interest deferral “raises more questions about what might happen to hybrid and other subordinated debt at other banks the government owns or might end up owning”.
That’s why, if you are tempted to buy Pibs or other forms of bank debt, you should only invest “money you can afford to lose”. The high yields available reflect the risk that you’ll lose everything.
However, for anyone willing to take that risk – after all, the best returns are usually available when others are most fearful – a few perpetual bonds are worth a look, reckons Riccardo Marzi in his Events Trader newsletter. Plenty of banks and building societies have stayed out of the clutches of the government, and even some of those that have been bailed out – such as Northern Rock – are still making payments to bondholders.
One of Marzi’s tips is a Barclays 7.5% 2010 bond, which currently has a yield to maturity of 42.7% (the ISIN code to quote your broker is XS0110537429). Among building societies, Nationwide has a 6.02% 2013 bond, currently offering a yield to maturity of 31.9% (ISIN XS0284776274). The yield to maturity is the annual return you’ll make if you hold the bond until the redemption date, assuming all goes to plan. Remember the spreads on these bonds can be wide, particularly if you are buying in small quantities.
What went wrong at Bradford & Bingley?
B&B demutualised and listed on the stock exchange in 2000, resulting in pressure to generate quick returns. The group began lending to amateur landlords and high-risk borrowers, who at one point made up 80% of its lending. It plugged the gap between deposits from savers and the amount it lent out with short-term loans from other institutions.
But the credit crunch cut off this wholesale funding, while high-risk mortgagees began defaulting. To prevent its collapse, Spanish bank Santander took over its savings business last September, while the UK government took on its flawed loan book and creditors such as PSB holders. The Treasury’s deferral of the PSB coupons breaks no rules – PSB holders rank behind savers and other lenders such as the government, which has injected around £18bn into the bank.
What irks B&B investors is the contrast with Northern Rock and even HBOS, whose Pib holders aren’t losing out. The government argues that both those firms are “going concerns”, whereas B&B is being wound down after the sale of its savings unit. The move raises questions as to how safe debt-holders in other banks will be should history repeat itself.