The Co-op, Nationwide, PSB, PIBS and diversification of risk

by George Hatjoullis

This is a blog I never thought I would need to write and it depresses me a little to be doing so. In the dim and distance past, as a finance academic, the first thing I taught was the magic of diversification. If asset returns are less than perfectly positively correlated then holding more than one asset will reduce your risk as measured by the standard deviation of your portfolio return. The key point is that holding a disproportionate amount of your portfolio in any one asset or class of assets is not normally a good idea. This is especially true if the asset is also very risky in its own right.

There are many types of risk but the type I have in mind here is credit risk. It is the risk that the promise to pay back the principal and interest is not fully honoured. It is ever-present in debt contracts with the notable exception of some government debt contracts e.g. gilts. I say some contracts because the eurozone crisis is all about the realisation that the debt of eurozone member states carries some credit risk. The reason is the relationship between the UK Treasury and the Bank of England is quite different to that of, say, the Greece Treasury and the ECB. If you put all your money in a single gilt or a national savings product you can be 99% certain you will get back whatever you are promised, if you hold to maturity. If you spread your cash around banks so that you only have £85k in each separately licensed bank, you can expect your cash to be safe and interest paid. All other assets carry some credit risk, and risk of default and loss at default.

Any sum of cash held in a bank account above the insured amount carries some risk it will be sequestered. If you are in any doubt see the many blogs on Cyprus and banking below. If you have all your wealth in one bank then it is possible, though not necessarily probable, that you could lose it all. However, the bank deposit, like the senior bond issued by a bank, ranks higher in the credit standing of bank debt than junior or subordinated debt. If the bank gets into difficulties then the junior debt will be sequestered before senior debt and deposits. Junior debt includes Permanent Interest Bearing Shares (PIBS) and Perpetual Subordinated Bonds (PSB).

PIBS and PSB have substantial credit risk. The former are issued by building societies and the latter by banks. Both typically have high coupons (yields) at issue to reflect this risk. The terms vary and may include the right not to pay interest if the institution so chooses and not to ever pay the missed payment (non-cumulative). Because it is contractual such a missed payment would not constitute a default event. The contract may include the right to call the bonds at par. This means that if interest rates fall and the market price of the PIBS/PSB rises above 100 the institution may give the holder a 100 and reissue at the prevailing yield. Basically, PIBS/PSB are risky bonds and it is best not to have a lot of your wealth invested in the issues of one institution. This is why they offer such high yields!

Low interest rates and low annuity rates has resulted in many income seekers investing disproportionately large amounts in such bonds. It is not possible for individuals to properly diversify holdings of these bonds because there are simply not enough issues. Even then, this class of bonds would be subject to systemic risk. The denominations are often large and the dealing costs (brokerage and bid/offer spread) very high. PIBS/PSB are assets that could lose all their value. It makes no sense for anyone to invest a significant proportion of their portfolio in any one asset that could lose all its value. Diversification is essential. PIBS/PSB could be a small part of an otherwise well diversified portfolio but the stories of people investing half their pension sums in such instruments are very disconcerting. Poor judgement and poor advice are implicated.

The problem with the Co-op PSB has been well documented in previous blogs. The Nationwide has a buy-back programme for its PIBS. It is offering to buy back bonds at below par. It makes sense for the Nationwide because it is buying back expensive capital. It can raise new capital more cheaply. Of course one does not need to sell. If one does not sell one is left holding a bond which has a much smaller outstanding issue and less liquidity. The bid/offer spread may widen further and make it more expensive to sell in the future. Moreover, one must ask why Nationwide are buying PIBS. If it is concluded that it might reflect capital needs then one can never be sure what the Nationwide might resort to in relation to the PIBS in future. If an individual is overly dependent on income for Nationwide PIBS then she/he might do well to review the investments and even take professional advice.

Generating income from capital is difficult at the moment, especially if one is looking for some inflation uplift. However, the problem cannot be solved by simply taking more risk than the investor can afford. A crude test is to ask if you could in principle lose all the value of one asset or class of assets and how this would leave you. If the answer is ‘desperate’ then you are holding too much of this asset class even if you believe the probability of such an outcome is very low. If it is not a gilt or national savings or an insured deposit then you need to review.

For most people, effective diversification is difficult. First, they do not understand risk. Second, their portfolio is too small to effectively diversify. Third, their income needs exceed what is easily achieved through low risk assets. To get some idea of what is available from a properly diversified portfolio take a look at the yield on a selection of income funds. If you are achieving much more, then you are probably taking more risk than you should. You may be lucky and continue to reap the rewards of the higher risk but luck does constitute a good investment strategy. I recommend a review.