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
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

July 15th 2015

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