Jan 30

Charles Smith Remembered

I was saddened to learn of the sudden death earlier this week of Charles Smith following a suspected heart attack. Charles, a partner in Brodies LLP, was widely acknowledged as one of the foremost environmental and energy lawyers in Scotland, at a time when the regulatory framework applying to both was in a state of rapid flux, requiring careful interpretation and application.

We worked together on the modern equivalent of alchemy – an ambitious attempt to turn mixed garbage, if not into gold, then at least into the equivalent of oil – a reliable and sustainable source of renewable energy. The technical advisers must determine whether this will work; the financial advisers (myself, in this instance) must assess whether it is affordable; but it is the lawyers who arguably have the most challenging and essential task of giving commercial reality to a project through a robust contractual structure. Some of Charles’ most important work must, of necessity, remain commercially confidential; but his published guidance on energy supply companies provides an enduring template of how such projects can be structured. It will remain one of my key references for as long as I advise on renewable energy projects.

Blessed with a first-class intellect, an ability to explain complex legal provisions in clear and understandable English, an encyclopaedic memory and the forensic ability to identify and correct any areas of potential inconsistency or ambiguity in legal drafting, he was an essential member of a team at the leading edge of innovative renewable energy technology. His passing, at the peak of his powers, leaves a gap that will not easily be filled.

I salute a man of many qualities, and mourn the loss of a respected colleague and valued friend.

Michael Nevin
January 30th 2016

Permanent link to this article: http://www.goldenguinea.com/charles-smith-remembered/

Jan 29

A Land Value Tax for Scotland

The devolution of greater financial powers to Scotland presents both a threat and an opportunity.

The threat is that growth and productivity in the Scottish economy could be adversely affected if taxes are poorly designed or applied at higher rates than in England. This risk was highlighted by the Government’s proposals in late 2014 to introduce a Land and Buildings Transactions Tax (LBTT) at a significantly higher rate than in England, at 10% on residential transactions between £250,000 and £1 million, compared to 3% in the rest of the UK up to £0.5 million, and 4% between £0.5 million and £1 million. Unsurprisingly, these proposals provoked a sharp backlash and forced the Finance Secretary into an embarrassing climbdown.

On a more positive note, greater tax powers present an opportunity for The Scottish Government to rationalise and streamline the tax structure inherited from the rest of the UK to promote growth and jobs in Scotland.

At the moment, three taxes account for around 80% of all fiscal revenues raised at UK level – income tax and National Insurance contributions; VAT; and corporation tax. These are likely to remain the principal sources of revenue for The Scottish Government, and are broadly viewed as “good taxes” by economists – being reasonably easy to assess and collect, regarded as fair by those upon whom they are levied (within limits), and efficient in that they do not unduly distort the workings of the free market.

The same cannot be said for the 10% of fiscal revenues accounted for by three property taxes – LBTT, expected to raise approximately £0.5 billion annually for The Scottish Government, Council Tax (frozen since 2008), which raises £1.8 billion annually in Scotland, and national non-domestic rates levied on businesses, which raise approximately £2.6 billion annually.

My proposal is that these three taxes should be replaced by a single Land Value Tax (LVT), levied on the unimproved value of land, introduced on a fiscally neutral basis. In other words, the rate of LVT would be set to raise approximately the same amount as the combined total of LBTT, Council Tax and national non-domestic rates, or around £5 billion annually. On a rudimentary analysis, this would imply that a land value tax would be levied at a rate of approximately 0.5%, or £500 per £100,000 of unimproved land value annually.

A Land Value Tax would offer a number of advantages, including the following:
1. It would be cheap and easy to administer.
2. It is impossible to evade, as land cannot be hidden.
3. It is efficient, in that it does not discourage enterprise, effort or productivity. Since the taxation base is the unimproved value land, families who chose to improve their homes and thus enhance their market value would not be penalised by a higher tax rate – unlike the poorly conceived proposals for a Mansion Tax (which now, happily, seem to have died a death).
4. The taxation base would be easy to assess and update. Unimproved site values could be independently calculated by the RICS Scotland on a quinquennial basis, using data provided by completed market transactions.
5. Landowners who chose to leave their land in an unimproved condition would pay exactly the same rate per acre or per square metre as landowners who have invested in the development of their estates. For this reason, it would eliminate the need for regulations, such as those proposed by The Scottish Government, intended to force landowners to enhance their estates – and, even worse, threaten them with expropriation if they fail to do so. This regulatory approach owes more to the ideology of Joseph Stalin or Mao Tse-tung than the philosophy of Adam Smith, and, unsurprisingly, has provoked strong criticism. It doesn’t take Nostradamus to predict that, were such regulations ever to be implemented, they would almost certainly have a significant negative impact on the Scottish economy, undermining confidence and private sector investment. By contrast, in the words of Henry George, “land value tax prevents private investors from profiting from the mere possession of land, while allowing the value of all improvements to land to remain with the investors whose efforts secure it.”
6. Unlike LBTT, receipts from the tax would not go up and down with the economic cycle, but remain stable through time, because the taxation base would be the underlying land value rather than the number of property transactions.
7. As the experience of other domiciles demonstrates, LVT can be applied at State level within a Federal system, for example in New South Wales in Australia and Pennsylvania in the USA.

Because of these advantages, Land Value Tax has been advocated by a wide range of economists, including Henry George, William Vickrey and Milton Friedman, who stated in Economica in 1980 that “in my opinion, the least bad tax is a property tax on the unimproved value of land.” More recently, Scottish economist James Mirrlees, a Nobel Prize winner, advocated the use of a land value tax in his report to the Institute of Fiscal Studies on The Dimensions of Tax Design: The Mirrlees Review in 2010.

Finally, the introduction of a land value tax, set and collected at local authority level, could help cut through the growing tensions between central government and local authorities, who are complaining (in my view, with some justification) that the national freeze on Council Tax that has applied since 2008 is making it increasingly difficult for them to fund essential local services.

To date, The Scottish Government has, perhaps understandably, pursued a broadly cautious approach in applying the greater taxation powers at its disposal. However, a more radical approach is required to address growing tensions in the local taxation system, and the politically sensitive issue of land reform. A Land Value Tax would address both issues, in a way that is economically efficient and would promote productivity, growth and job creation in Scotland.

MJN
29/1/2016

This article was originally published on the Wealthy Nation Institute website, http://www.wealthynationinstitute.com/ on January 26th

Permanent link to this article: http://www.goldenguinea.com/a-land-value-tax-for-scotland/

Jan 12

The Kondratieff Wave and the Bond Market

Following commentary over the past three months on the Kondratieff cycle, the question has been raised as to how an investor can tell whether financial markets are in the upswing or downswing phase of a long wave.

During the upswing, private sector investment is strong and rising; share prices increase over time in real terms; and, reflecting buoyant economic activity, there is upward pressure on real interest rates.

By contrast, during the downswing, private sector investment is weak, equity indices are static or falling in real terms, and there is downward pressure on real interest rates.

It is relatively straightforward to identify whether financial markets are in a secular upswing or downswing by drawing time series charts of the annual average values of these three variables.

During an upswing, equities outperform bonds. This doesn’t mean that bear markets never occur in equity markets during an upswing – they can and do, but they will be relatively brief interludes in the upward march of equity prices. George Ross-Goobey, the pension fund manager of Imperial Tobacco, was therefore right to shift their funds out of bonds and into equities in the 1950s, during the early stages of the post-war upswing. He did so because dividend yields were higher than bond yields, and because he accurately foresaw that dividends would rise over time in line with the underlying growth of the British economy.

He was also right to shift out of equities back into government bonds (gilts) at the tail end of the post-war upswing. His obituary in the Telegraph in 1999 reported that, “By the end of the 1960s, Ross-Goobey perceived that the price of shares had risen perhaps too far with the emergence of the “reverse yield gap”, i.e. the yield on gilts was higher than that on shares, buying gilts heavily in 1974 when yields rose to over 15 per cent.”

This was at the beginning of a long wave downswing, and his timing was impeccable.

Though Ross-Goobey is long gone, the tactics he deployed through the long wave of his career remain valid today. The upswing of the Internet long wave broke on the international financial crisis of 2007-09 and we are now in a downswing. In such an economic environment, bonds represent a safer investment than equities and offer the prospect of superior returns over time. As noted in earlier comments, equity prices as measured by the FTSE 100 (and I suspect other international indices such as the Dow-Jones) have fallen significantly since the financial crisis, while bond prices have risen.

There is of course the risk that a distressed company could default on its bond payments, and the financial markets are pricing in this risk for the securities held in the Golden Guinea High Yield Portfolio. All 10 securities currently held in the portfolio are offering yields that indicate market participants believe they carry a significant default risk.

So too does the 11th security purchased this month, the senior bonds issued by International Personal Finance (IPF), currently quoted on ORB at less than 90 pence in the £.

IPF was spun out of the overseas loans arm of home credit company Provident Financial in 2007, since when it has pursued an active growth strategy particularly in eastern Europe and Russia. It operates through a network of 30,000 part-time agents, who advance loans to borrowers unable to access credit from the banks. This is reflected in high default rates, with IPF accepting that between 25% and 30% of the loans it advances will not be repaid, and the interest rates it charges reflect this risk. However, its business model is threatened by efforts by regulators, particularly in eastern Europe, to restrict high-cost credit. IPF announced in December 2015 that proposed legislation in Slovakia “will have a material adverse financial impact on its existing Slovak business”, following similar legislation in Poland.

These restrictions have led to a downgrading of IPF’s corporate debt. Equally, an earlier announcement accompanying the company’s third quarter results stated that “We expect to deliver continued strong growth in Mexico and through our digital businesses….Notwithstanding the challenges in growing the top line in our European home credit business, we are confident that the result for the year as a whole will be broadly in line with consensus,.”

This suggests that IPF’s operations are sufficiently diversified, both geographically and operationally, to ride out temporary turbulence in particular markets.

At current prices, IPF’s bonds offer a running yield of 7% and a yield to maturity in excess of 9.5%. If the High Yield Hypothesis (HYH) is valid, then financial markets tend to overreact to temporary bad news, driving security prices below their true value. The IPF bonds represent a test of this hypothesis.

Issuer: International Personal Finance Plc
EPIC: IPF1
Coupon: 6.125%
Maturity Date: May 8th 2020
Payment Dates: 6-monthly on May 8th and November 8th
Offer Price: 87.975
Running Yield (at Offer Price): 7.0%
Yield to maturity (at Offer Price): 9.6%
Nominal Amount: £1,000
Cost: £879.75 + £7.95 commission = £887.70

MJN
January 12th 2016

Permanent link to this article: http://www.goldenguinea.com/the-kondratieff-wave-and-the-bond-market/

Dec 14

Pricing Anomalies in the Fixed Income Market

By comparison with the market for equities, the London corporate bond market remains illiquid and imperfect. The LSE has done its best to improve matters by introducing the Order Book for Retail Bonds (ORB), publishing up-to-the-minute information on its platform on the volume and price of bonds traded, breaking news and financial results. But there are structural barriers mitigating against a smooth, perfectly competitive and liquid market. Prime among these is a paucity of market-makers. Banks are increasingly wary of holding large amounts of bonds on their balance sheet or are constrained from doing so by regulatory and capital requirements. Consequently, even quite small trades can cause sharp and discontinuous price movements, and there remain apparent anomalies in the pricing of different securities issued by the same company.

One example that caught my eye relates to the different classes of Permanent Interest-Bearing Shares (PIBS) issued by the Skipton Building Society. The Skipton is a small building society with total assets at its most recent balance sheet date of just under £16 billion, and total equity of just under £1.1 billion. It has three PIBS currently quoted on the LSE, in alphabetical order by EPIC code as follows:

SBSA: 8.5% PIBS quoted at an Bid price of 128 on December 14th 2015, and an Offer price of 138, implying a yield of 6.15% (= 8.5%/138) at the Offer price.

SBSB: 6.875% PIBS quoted at a Bid price of 91.5 and an Offer price of 97 on December 14th, implying a yield of 7.09% at the Offer price.

SKIP: 12.875% PIBS quoted at a Bid price of 193 and an Offer price of 203 on December 14th, implying yield of 6.32% at the offer price.

The notes to the building society’s accounts state that “all PIBS are unsecured and rank pari passu with each other.”

There is a wide spread between the Bid and Offer prices of all three issues, in excess of 5%. The value of all three issues is small, ranging from £16 million in the case of the 8.5% securities to £47.3 million in the case of the 6.875% issue. LSE data indicates that they trade only in small amounts and relatively infrequently. Their price charts on the LSE website reveal sharp discontinuous price movements, with occasional spikes upwards or downwards, followed by long periods when the price doesn’t change at all. These are all indicators of a very narrow and illiquid market.

Anyone investing in such a market would be well advised to “buy and hold”, as the capital of active traders would be rapidly eaten up by the wide Bid / Offer spread. In the event of any downturn in security prices, the only viable strategy is to sit tight and ride out temporary turbulence. This is true of all the bonds held in the Sterling High Yield Portfolio.

The question is this: how can it make sense for three securities, issued by the same firm and ranking equally for payment, to offer yields that are 1% apart? The yield on the 8.5% issue stands at 6.15%, while the yield on the 6.875% issue stands at 7.09%.

This is not a rhetorical question – if anyone can offer an explanation, I would be delighted to know what it is.

My final observation is that, in an economically deflationary environment – the downswing of the long wave (as discussed in my comment last month) – a yield in excess of 7% on a fixed income security issued by what appears to be a stable, prudently run and profitable financial institution is a good return. So the Skipton 6.875% issue becomes the 10th investment within the High Yield Bond Portfolio.

Issuer: Skipton Building Society
EPIC: SBSB
Coupon: 6.875%
Maturity Date: Undated
Payment Dates: 6-monthly on April 15th and October 15th
Offer Price: 95.75
RY at Offer Price: 7.2%
YTM at Offer Price: 7.2%
Nominal Amount: £1,000
Cost: £957.50 + £7.95 commission = £965.45

MJN
December 14th 2015

Permanent link to this article: http://www.goldenguinea.com/pricing-anomalies-in-the-fixed-income-market/

Nov 10

Schumpeter, Minsky and me: Long waves in British financial markets – Part 2

My analysis indicates that we are now in the downswing of the fifth long wave in British financial markets since the Industrial Revolution. The upswing ended with the international financial crisis of 2007–09, and one would expect that the downswing will endure for between 20 and 25 years and evolve in two phases, each lasting approximately a decade: a recessionary phase which is now coming to an end, when the bad debts built up to fund speculative investments during the final bubble of the upswing are progressively liquidated; followed by a recovery. The recovery is likely to be characterised by consolidation, defensive mergers and the emergence of innovations that will drive the next upswing. As Kondratieff observed, “during the long wave downswing, a large number of important discoveries and inventions are made, which however are usually applied on a large scale only at the beginning of the next long upswing.”

The inflection point of each of the five long waves was marked by a major financial crisis, which is now sometimes termed as a Minsky Moment, after Hyman Minsky (1919-1996). Minsky was a student of Schumpeter at Harvard University during the 1940s, and like Schumpeter and Keynes, he recognised that capitalist economies do not converge to a stable general equilibrium in the way set out in conventional textbooks, but rather progress in a cyclical fashion. He also recognised that credit-financed speculation drives economies far above their natural rates of growth towards the end of the long wave upswing, leading inevitably to a financial crisis. These crises are the economic equivalent of a heart attack, when the entire financial system seizes up and there are widespread banking failures.

Individual banking failures can occur at any time. What is different about Minsky Moments is that they go beyond the failure of one or two individual banks in isolation, to a wider systemic collapse which ripples from one institution to another causing severe credit contraction and choking off the normal flow of funds from savers to borrowers.

Such moments occur once in a generation, and mark the inflection point from upswing to downswing. They are clearly identifiable in each of the five long waves since Industrial Revolution:

1. The Industrial Revolution
Upswing: 1785–1814
Inflection point: 1814–15
Downswing: 1815–1844

2. The Railway Revolution
Upswing: 1844–1873
Inflection point: The Panic of 1873
Downswing: 1873–1896, aka the Long Depression

3. The Automobile Revolution
Upswing: 1896–1929
Inflection point: The Crash of 1929 followed by banking crises and collapse of the Gold Standard in 1929–1932
Downswing: 1929–1948: The Great Depression followed by the Second World War

4. The Aerospace Revolution
Upswing: 1948–1971
Inflection point: The Secondary Banking Crisis of 1972–1974
Downswing: 1972–1992: The collapse of the Bretton Woods system followed by Stagflation during the 1970s and Recovery during the 1980s

5. The Internet Revolution
Upswing: 1992–2007
Inflection point: The International Financial Crisis of 2007–2009
Downswing: 2007 –

After each inflection point, the British Government of the day responded by introducing reforms to restore confidence in the banking system.

Paradoxically, my observation is that the safest time historically to invest in bank securities is in the aftermath of a Minsky Moment. It is such a cathartic event that the last thing survivors are likely to do is to repeat the mistakes that brought down their competitors. Gone are the reckless lending practices of the upswing’s final bubble. Gradually, bad and doubtful debts within the banking system are written down. The capital base of surviving banks is rebuilt to more prudent levels, often at the behest of the regulatory authorities. The priority of Bank Directors is to ensure their own survival. Above all, they seek to avoid the scandals and imprudent lending practices that destroyed the reputations and careers of their predecessors.

At the same time, new banking institutions emerge. Today they are called Challenger Banks, which are building up their loan books and market share at the expense of long established incumbents – banks like Virgin, Metro, Aldermore, First Direct and OneSavings.

During the period that follows a Minsky Moment, yields on bank bonds are likely to be exceptionally high, coming down only gradually as a fragile confidence returns.

Thus, somewhat to my surprise, running the numbers through my spreadsheets, I find that, today, the highest yielding security yet to be included in the Experimental High Yield Portfolio are a class of perpetual subordinated bonds issued by OneSavings Bank. This is despite the fact that the bank has reported excellent financial results, with new loans and advances of £986 million in the first 9 months of 2015 increasing its total loan book by 25% to £4.9 billion, accompanied by strong margins, a sound capital base and upward re-ratings by most analysts tracking the stock.

So the Perpetual Subordinated Bonds issued by the bank become the ninth security to be added to the portfolio.

Issuer OneSavings Bank plc
EPIC 1SBA
Coupon 6.591%
Maturity Date Undated, but callable on March 7th 2016
Payment Dates Half yearly on March 7th and September 7th
Offer Price 95.7
Running Yield (at Offer Price) 6.9%
Yield if called (at Offer Price) 16.3%
Nominal Amount £1,000
Cost £968.95 (inclusive of £11.95 accrued interest) + £5.75 commission = £974.70

MJN
November 10th 2015

Permanent link to this article: http://www.goldenguinea.com/schumpeter-minsky-and-me-long-waves-in-british-financial-markets-part-2/

Oct 13

Palmerston, Kondratieff and Me. Long waves in British financial markets.

The Victorian statesman Lord Palmerston once observed of the Schleswig-Holstein question that it was so complex that only three men had ever fully understood it. One of them had gone mad, the second had since sadly died, and the third was himself – but it was so long ago that he had completely forgotten the answer.

Sometimes I feel as if the long waves that drive capitalist development have also, like the Schleswig-Holstein question, only ever been understood by three men. The first, Nikolai Kondratieff, disappeared long ago into one of Stalin’s Gulags, never to be heard of again. The second, Joseph Schumpeter, has long since passed on. The third is myself, and my only published analysis of it was in The Age of Illusions more than 30 years ago.

Actually, I’ve undertaken much research since then, not with a view to publication, but rather to apply the analysis as a framework for trading in the securities markets. It worked, thus reinforcing my confidence in the existence of the long waves that Kondratieff first identified 90 years ago.

The secrets to success in surfing the long wave are threefold: firstly, to recognise that it exists; then, to anticipate its movement going forward; and finally, to take a position to ride it and avoid being overwhelmed and submerged.

Going through each in turn:

1. Recognising the wave. Conventional wisdom as taught in academic textbooks and finance courses is that capitalist development is a process of incremental change within an inherently stable system. Kondratieff and Schumpeter realised that the real world doesn’t work like this. Market economies have no natural tendency to equilibrium. As Schumpeter wrote in Capitalism, Socialism and Democracy, “The capitalist economy is not and cannot be stationary. Nor is it merely expanding in a steady manner. It is incessantly being revolutionized from within by new enterprise or new methods of production or new commercial opportunities” which sweep away existing market structures in what he termed a “gale of Creative Destruction”.

2. Anticipating the movement of the wave. We are currently in the downswing of the Internet Revolution – the fifth long wave in the UK since the Industrial Revolution. The upswing of the Internet Revolution lasted from the late 1980s to 2007, driven by major innovations including the mobile phone, laptop computers and the worldwide web. As the upswing gathered pace, imitators keen to emulate the success of entrepreneurs like Steve Jobs and Bill Gates entered the market, driving a speculative bubble fuelled by lax monetary policies. The bubble fed on itself in a reflexive process (in George Soros’s phrase), pushing asset prices ever further from their economic values particularly in Internet-related businesses and property, until they crashed during the international financial crisis of 2007–09. We are now in the downswing of the Internet Revolution, which will evolve in two phases. The first phase is Recession, when poor investments made during the final speculative bubble and the loans that financed them are progressively purged from the economic system. The Recession will be succeeded by a Recovery, as insolvent enterprises are liquidated, surviving enterprises consolidated, and new enterprises emerge.

3. Investment positioning through the long wave. In general, the long wave upswing tends to be inflationary, while the downswing is deflationary or disinflationary. So the upswing is generally positive for equities, whose prices rise in an inflationary environment. But it is bad for bonds and other financial assets whose nominal value is fixed and whose real value falls as the general price level rises. Conversely, the long wave downswing is generally bad for equities but good for bonds.

This has been the story since 2007: Equities have suffered while bondholders have prospered. When the Internet Revolution approached its peak back in March 2007, the FTSE 100 Index stood at 6300. Today, 8½ years later in mid-October 2015, it stands at…..around 6300. At the risk of stating the blindingly obvious, equities as an asset class have gone absolutely nowhere during the Recession phase of the current long wave. In fact, in real terms, they have fallen significantly in value, as over the same period the UK Retail Price Index has increased almost a quarter from 210 to 260.

By contrast, bond prices have shown significant gains over the period. The yield on the benchmark 10-year UK gilt stood at 5% in March 2007. Today, it is just 1.9%. As bond yields have fallen, bond prices have risen.

At some point, as Recession metamorphoses into Recovery, one would expect bond prices to fall and yields to rise, but only slowly and by modest increments. In such circumstances, bonds as an asset class may continue to outperform equities. In any event, with the UK inflation rate currently at 0%, the yield of 6½% offered by the eighth bond acquired for the High Yield Bond Portfolio appears attractive, being 4½% higher than the 10-year gilt yield. Its details are as follows:

Issuer: Enterprise Inns plc
EPIC: AK44
Coupon: 6.375%
Maturity Date: September 26th 2031
Payment Dates: 6-monthly on March 26th and September 26th
Offer Price: 99.85
Running Yield (at Offer Price): 6.38%
Yield to maturity (at Offer Price): 6.39%
Nominal Amount: £1,000
Cost: £998.50 + £3.59 accrued interest + £20 commission = £1,021.09

Permanent link to this article: http://www.goldenguinea.com/palmerston-kondratieff-and-me-long-waves-in-british-financial-markets/

Sep 11

Premier Oil and the High Yield Hypothesis

During market dips, it is worth recalling the words of Warren Buffett –

“Be fearful when others are greedy; be greedy when others are fearful.”

Security prices go up and security prices go down, but the coupons paid on bonds go on forever – steady, predictable and reliable. While they offer no upside beyond the prospect of redemption at par, their downside is also limited, always provided that they do not default. And even in default, bonds rank ahead of shares, so while the equity of a company running into serious financial difficulties is likely to be worthless, bondholders may still recover something from the wreckage.

So bonds tend to outperform equities in bear markets, but underperform during a bull market. Thus, while the FTSE 100 has dropped by 13% since the end of May from 7000 to around 6100 today, the average price of the bonds quoted on the LSE’s Order Book for Retail Bonds (ORB) has fallen by less than 4%. The capital value of our embryonic High Yield Bond Portfolio has fallen by 8%, or about half-way between equities and investment grade bonds, with the worst performer being the Rea Holdings preference shares acquired last month, which tanked by 20% when the company announced disappointing interim results a couple of weeks later.

Clearly, a fall in the portfolio’s capital values is never welcome. But realistically it is to be expected at some point, and is compensated by the annual yield of 7.4%. As long as the bonds continue to pay interest on the due dates, then short term market fluctuations have limited relevance.

The more fundamental question is whether the portfolio yield accurately discounts default risk or, as the High Yield Hypothesis (HYH) postulates, over-discounts this risk, offering the potential for returns superior to those that could be secured on equities or investment-grade bonds over the longer term.

Even after the recent falls in security prices, only three bonds are trading below their par value on ORB – Eros, EnQuest and Premier Oil. The first two are ready in the high yield portfolio. The third, Premier, is, like EnQuest, an oil exploration and development company, and as such has been hit not only by general market risk but also by sector-specific risk as global oil prices have tumbled. With global oil production running at around 97 million barrels per day, against consumption of 94 million bpd, oil stocks are building up and there is downward pressure on prices. At some point, the market will be brought back into balance. If demand does not increase, then some sort of a crisis is likely to occur on the supply side, potentially including severe cutbacks in production, the bankruptcy of marginal producers, and defensive mergers among the survivors.

The crisis could go wider than that. In an uncharacteristically lurid leader published on Thursday August 13th entitled “The world’s producers are boiling in cheap oil”, the Financial Times predicted that continued low oil prices could inject dangerous volatility into international politics and destabilize major oil producers including Russia and Saudi Arabia. “Countries in dire financial straits may feel forced into aggressive responses,” according to the FT’s jeremiad. “Periods when the global balance of power is changing are also times when international tensions can flare up. We are perhaps in just such an era today. Policymakers around the world need to be on the alert for the conflicts and upheavals that may yet result.”

The test of the true contrarian is whether he or she is prepared to buy when the Barbarians are at the gate. According to the FT, that moment may be fast approaching for the oil industry. Right now, investing in the bonds of a relatively small, highly leveraged oil exploration and production company has all the appeal of the Loony Dook on a freezing New Year’s day.

Is the high yield bond portfolio the construct of an ice cool contrarian keeping his head while all about lose theirs? Or is it the reckless gamble of a foolish speculator who rushes in where more prudent investors fear to tread?

Only time will tell. In the meantime, following the precepts of the HYH, Premier Oil’s 5% bonds become the seventh investment within the portfolio.

Issuer: Premier Oil Plc
EPIC: PMO1
Coupon: 5%
Maturity Date: December 11th 2020
Payment Dates: 6-monthly on June 11th and December 11th
Offer Price: 81.18
Running Yield at Offer Price: 6.1%
Yield to Maturity at Offer Price: 9.5%
Nominal Amount: £1,000
Cost: £811.80 + £12.98 accrued interest + £5.75 commission = £830.53

MJN
September 11th 2015

Permanent link to this article: http://www.goldenguinea.com/premier-oil-and-the-high-yield-hypothesis/

Aug 10

In Praise of Preference Shares

Preference shares are today a relatively neglected instrument of corporate finance. The current conventional wisdom of the City is that they offer none of the upside of ordinary shares and none of the tax advantages of loan notes.

I have an alternative perspective. True, preference share dividends are not tax deductible, unlike loan interest payments. But this is less of a disadvantage today, with corporation tax now 20% and due to fall to 18%, than when the rate of corporation tax stood at 30% back in 2007. And preference shares offer two major advantages over senior bonds or loans from the viewpoint of the companies that offer them:
• they do not need to be repaid – they are a form of permanent capital; and
• if the issuing company runs into temporary financial difficulties, it can pass the dividend payment on its preference share without risking insolvency.

For the investor, preference shares offer a steady and predictable source of income, with a higher yield than corporate bonds – more than 3% higher today, in fact, with prefshares generating an average yield of 6¼% at their Offer prices, compared to an average yield of barely 3% on bonds quoted on ORB. In addition, preference share dividends are more secure than those on ordinary shares. Overall, they occupy a useful position on the risk–return spectrum, which is why it is somewhat disappointing that my research identified just 22 preference shares which are suffiicently liquid to be easily purchased by a retail investor. For the record, the 22 prefshares, with their offer price and yield at August 10th 2015, were as follows:

[1] Aviva 8.75% Cumulative Irredemable Preference Shares [EPIC: AV.A]. Offer Price 139.5. Yield 6.27%.
[2] Aviva 8.375% Cum Irr Pref [AV.B]. Offer Price 136.5. Yield 6.12%.
[3] Balfour Beatty Cumulative Irredemable Preference Shares [BBYB]. Offer Price 119. Running Yield 8.03%. Yield to Maturity: 4.91%. (Note that the Balfour Beatty convertible issue is repayable on July 1st 2020 at 100, implying a loss of 19% on the current offer price, and for this reason their yield to maturity is significantly lower than their running yield).
[4] BP 8% Cum Irr Prf [BP.A]. Offer Price 152.75. Yield 5.24%.
[5] BP 9% 2nd Cum Irr Prf [BP.B]. Offer Price 169. Yield 5.33%.
[6] Bristol & West 8.125% Pref [BWSA]. Offer Price 127.5. Yield 6.37%.
[7] Bristol Water 8.75% Cum Irr Prf [BWRA]. Offer Price 152.5. Yield 5.74%.
[8] Ecclesiastical Insurance 8.625% Non-Cum Irr Prf [ELLA]. Offer Price 133.5. Yield 6.46%.
[9] General Accident 8.875% Cum Irr Prf [GACA]. Offer Price 139.5. Yield 6.36%.
[10] General Accident 7.875% Cum Irr Prf [GACB]. Offer Price 131.0. Yield 6.01%.
[11] Lloyds Bank 9.25% Non Cum Irr Prf [LLPC]. Offer Price 142.75. Yield 6.48%.
[12] Lloyds Bank 9.75% Non Cum Irr Prf [LLPD]. Offer Price 151.0. Yield 6.46%.
[13] Lloyds Bank 6.475% Non Cum Irr Prf [LLPE]. Offer Price 109.0. Yield 5.94%.
[14] National Westminster Bank 9% Non Cum Prf [NWBD]. Offer Price 142.0. Yield 6.34%.
[15] Northern Electricity 8.061% Cm Irr Prf [NTEA]. Offer Price 146.5. Yield 5.50%.
[16] Raven Russia 12% Cum Red Prf [RUSP]. Offer Price 135.0 Yield 8.89%.
[17] Rea Holdings 9% Cum Red Prf [RE.B]. Offer Price 118.5. Yield 7.59%.
[18] RSA Insurance Group 7.375% Cum Irr Prf [RSAB]. Offer Price 125.5. Yield 5.58%.
[19] Santander 10.375% Non-cum Prf [SAN]. Offer Price 156.5. Yield 6.63%.
[20] Santander 8.625% Non-cum Prf [SANB]. Offer Price 130.5. Yield 6.61%.
[21] Standard Chartered 7.375% Non-cum Irr Prf [STAB]. Offer Price 121. Yield 6.10%.
[22] Standard Chartered 8.25% Non-cum Irr Prf [STAC]. Offer Price 130. Yield 6.35%.

Easily the highest yielding preference share on this list is the Raven Russia issue, which is already included in the high yield bond portfolio. The next highest yield is offered by the 9% preference shares issued by Rea Holdings, an Indonesian plantation owner and palm oil producer. For the most recent financial year ended December 31st 2014, the company generated revenues of just under £81 million, with pre-tax profits of £15 million. The dividend on the ordinary shares was covered 3.5 times, providing very solid protection for the preference share dividend. So the 9% preference shares become the sixth investment of the high yield bond portfolio.

Issuer Rea Holdings Plc
EPIC RE.B
Coupon 9%
Maturity Date Undated
Payment Dates 6-monthly on June 30th and December 31st
Offer Price 118.35
Yield at Offer Price 7.6%
Nominal Amount £1,000
Cost £1,183.50 + £5.75 commission = £1,189.25

MJN
August 10th 2015

Permanent link to this article: http://www.goldenguinea.com/in-praise-of-preference-shares/

Jul 15

The Structure of the London Fixed Income Market

A rapid recapitulation of the high yield bond system:

The objective of the system is to establish whether a diversified portfolio of high yield bonds outperforms other major asset classes. This premise is being tested through a designated Isa, into which one-twelfth of the annual Isa allowance is subscribed each month, and then used to invest in 12 high yielding fixed-income securities in blocks of £1000 nominal.

The monthly trades are executed on or about the 15th day of each month, and reported on this site immediately thereafter. This is to ensure complete transparency, and to avoid the risk of “backfitting”, or manipulating a theory to fit the historic facts after the event

The London fixed-income securities market comprises four main segments:

1. The gilt-edged market, comprising bonds issued by the British Government to fund its expenditure programme and managed on its behalf by the Bank of England’s Debt Management Office. There are currently 42 gilts listed on the Order Book for Retail Bonds, of which 18 are indexed linked and 24 conventional. Their yields are distinctly unappealing – the five-year gilt has a yield to maturity (YTM) of 1.1%, the 10-year gilt offers a YTM of 1.65%, and the 15-year gilt currently has YTM of just over 2%. At these yields, there is a real risk of capital loss should interest rates rise, and little upside. As one City wag has remarked, “Once, gilts offered return without risk; now, they offer only risk without return.”

2. The corporate bond market, which has become much more accessible to the small investor since the Order Book for Retail Bonds was set up in 2011. There are now more than 100 corporate bonds listed on ORB, offering an average YTM of between 2.5% and 3.0%.

3. The market for preference shares, once a popular security, but now with relatively few available to the small investor. By my reckoning, there are currently no more than 20 preference shares that are sufficiently liquid to include in an Isa portfolio. Although many more prefshares are listed on the LSE, they seldom trade and have little price transparency. The average YTM of the 20 liquid preference shares currently stands at just under 6%.

4. The market for subordinated debt and Permanent Interest-Bearing Shares (PIBS) issued by financial institutions as part of their risk capital base. My list currently includes some 40 subordinated loan notes and PIBS available to retail investors, offering an average YTM of approximately 6%.

No high yield portfolio would be complete without the inclusion of at least one Permanent Interest-Bearing Share. Yields on PIBS have fallen significantly from their peaks during the financial crisis, when at one point in July / August 2009 they spiked to over 14%. This was just after Northern Rock and the West Bromwich Building Society had suspended interest payments on their PIBS, the Dunfermline Building Society had collapsed, and the price of the 6% PIBS issued by the Bradford & Bingley had fallen to less than 10p in the £ (by mid-2014 they had recovered to more than 90p – whoever said that investing in fixed-income securities was boring?!).

The highest yielding PIBS currently quoted on the LSE are those issued by the Newcastle Building Society. In last weekend’s Money section of the Financial Times, two PIBS were listed as having higher running yields (RYs): the 11.5% Ulster Bank issue, and the 13.5% Yorkshire Building Society issue. However, this is misleading, because the Ulster Bank notes are subject to a 20% withholding tax, while the Yorkshires mature in April 2025, so their YTM is only 6.2%, compared to the 8.8% running yield quoted by the Financial Times.
The Newcastle PIBS avoid both of these bear traps. Note 12 to the Newcastle Building Society’s 2014 accounts confirm that the 12.625% and 10.75% PIBS are issued for an indeterminate period and only repayable in the event of a winding up of the Society.

The 10.75% PIBS (NBSP) have a coupon of 10.75% and are currently offered at a price of 156.1 giving an RY of 6.89% [= 10.75%/1.561], while the 12.625% issue (NBSR) is offered at 187, giving an RY of 6.75%. The 10.75% PIBS offer a marginally higher yield, so those are the ones added to the portfolio.

Issuer: Newcastle Building Society
Security: 10.75% Permanent Interest Bearing Shares
EPIC: NBSP
Coupon: 10.75%
Coupon Payment Dates: June 22nd and December 22nd
Maturity date: Undated, redeemable only in the event of a winding up
Offer Price: 156.1
RY at Offer Price: 6.89%
YTM at Offer Price: 6.89%
Nominal Amount: £1,000
Date of Purchase: July 15th 2015
Cost: £1,561 + £5.75 commission = £1,566.75

MJN
July 15th 2015

Permanent link to this article: http://www.goldenguinea.com/the-structure-of-the-london-fixed-income-market/

Jul 06

The Euro’s Existential Crisis

Extract from Chapter 11, ‘The Euro’s Existential Crisis’, in ‘The Golden Guinea. The International Financial Crisis, 2007-2014: Causes, Consequences and Cures’ (2012). Final section, ‘The Long Goodbye: Requiem for the Euro’.

“The inevitable conclusion is that the Euro cannot survive indefinitely in its current form…..Rigidly fixing national currencies to a single currency at an overvalued rate leads inevitably to deflation, which can only be brought to an end if the currency peg is sundered. That seems to be the most likely outlook for the Euro, although it is impossible to predict precisely when and how the single currency will finally break up.

The case put by supporters of the Euro for maintaining the single currency was that the alternative was so much worse. A research note issued by UBS in November 2011 commented that any nation exiting the Euro would face “corporate default, collapse of the banking system and collapse of international trade,” and probably experience a decline in GDP of between 40% and 50%. The scribes of UBS went on to add that, “almost no modern currency monetary unions have broken up without some form of authoritarian or military government, or Civil War.” In a separate research note, HSBC commented that “a breakup of the Euro would be a disaster, and in a worst-case scenario could trigger another Great Depression”. The economist Willem Buiter, and many others, painted a similar apocalyptic picture of a world without the Euro.

The narrative put forward by apologists for the European single currency completely discounted evidence of the damage done by the Euro in generating unsustainable Payments imbalances between Eurozone Member States, causing a destabilising asset price bubble that led to significant losses threatening the solvency of the European banking system. The Eurozone authorities then sought to address this threat by successive bailouts, adding to the national debt of sovereign states that were already over-borrowed. This led onwards to attempted fiscal consolidation on a scale that drove the continent of Europe into the most severe and prolonged recession seen since the Great Depression.

This was the legacy of the failed Euro experiment.

Throughout the Euro’s prolonged and painful death throes, Europe’s political elite asked the wrong question.

The question they were asking was, “How can we save the Euro?”

In reality, the ultimate fate of the Euro was already sealed. As Tolstoy wrote in ‘War and Peace’,

“Just as in the clock, the result of the complex action of countless different wheels and blocks is only the slow, regular movement of the hand marking the time, so the result of all the complex human movement – of all the passions, hopes, regrets, humiliations, sufferings, impulses of pride, of fear, and of enthusiasm of those men – was only… the slow shifting of the registering hand on the dial of the history of mankind.”

The question that needs to be asked is not how the Euro can be saved, but rather how it can be restructured in an orderly manner, to minimise its negative impact.

And, following from this, what should be put in its place.”

Permanent link to this article: http://www.goldenguinea.com/the-euros-existential-crisis/

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