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
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

December 14th 2015

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