100% Risk Nets Pimco 100% Return on U.K. Bank

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  • Funds bought bespoke capital shares from U.K. lender in 2013
  • Securities outperformed all major European, U.S. bond deals

Pedestrians pass a Nationwide Building Society branch in London.

Photographer: Simon Dawson/Bloomberg

When Europe was facing a possible second financial crisis four years ago, bond investor Mark Holman was pitched a novel security from a bank that would never repay his principal and could cut payouts at any time. He said yes.

Now the CEO of London-based TwentyFour Asset Management is sitting on a nearly 100 percent gain. The debt-like instruments issued by U.K. lender Nationwide have outpaced all major European and U.S. notes, according to data compiled by Bloomberg, handing big profit to investors that also include Pacific Investment Management Co. and BlueBay Asset Management Ltd. Other similarly risky bank securities returned just a third as much, and many have been more volatile.

“We embraced this new product,” said TwentyFour’s Holman, who has increased his stake since first investing. “Even we have been surprised at the performance.”

The securities that Nationwide Building Society sold in November 2013, known as core capital deferred shares, were a long shot. The U.K. economy was still climbing out of its longest peacetime slump in almost a century. The European Central Bank had warned just a few months before that economic weakness could weigh on asset quality for many lenders, which could have “systemic consequences.” Closer to home, Co-Operative Bank Plc was struggling to fill a 1.5 billion pound ($2 billion) hole on its balance sheet.

Nationwide’s securities seemed like a good wager though, partly because of their outsized payouts: 10.25 percent a year, said James Macdonald, an analyst at BlueBay in London. Also, the lender had stayed profitable during the financial crisis, and is a conservative underwriter of home loans that is willing to cut lending if pricing is too low, he said. The performance of these securities, which few other issuers sell, underscores that for all the risks in markets for European bank securities, the payoffs for attentive investors can be massive.

The 550 million pounds of core capital deferred shares that Nationwide originally sold have characteristics of debt and equity. They were designed to raise capital in place of a normal rights issue because Nationwide, owned by customers rather than investors, can’t issue shares.

Last week Nationwide sold a further 500 million pounds of the instruments. But this time investors bought them at almost 160 percent of their original value. Prices could hit 200 percent if the bank decides to hike distribution payments, the equivalent of dividends or interest, said BlueBay’s Macdonald. The payments can go up to almost 16 percent but can also go down depending on Nationwide’s performance. Because the instruments are perpetuals, the only way for an investor to cash in on price gains is to sell the securities to another money manager.

Other forms of risky bank securities, including stock-bond hybrids known as “contingent capital,” have followed a much rockier path since 2013. That market broadly plunged 10 percent at the start of 2016 amid fears that European banks including Deutsche Bank AG didn’t have enough capital. Even though the securities have since recovered, they’ve trailed core capital deferred shares. A Bank of America Merrill Lynch index of contingent capital has returned about a third as much as Nationwide’s CCDS since November 2013.

Read more about contingent capital securities including convertibles in this QuickTake

Investors demand higher yields for financial-sector debt than other corporate bonds because bank failures can happen unexpectedly - and fast. Junior creditors were wiped out following regulatory intervention at three European banks this summer, including 2 billion euros of Banco Popular Espanol SA notes that had traded at face value just two months earlier. Other lenders in Italy and the U.K. have imposed partial losses on creditors this year.

Even in 2017, there are still risks for Nationwide’s securities. U.K. economic growth this year has been the slowest among the Group of Seven nations, as concerns about the nation’s exit from the European Union weigh on the pound and investment. Nationwide’s chief economist is among the analysts forecasting a slowdown in residential real estate. Investors, though, are betting the U.K.’s second-largest mortgage provider has enough of a financial cushion to keep on paying its securities whatever happens.

“The U.K. property market is the clear risk but we don’t think they are under pressure,” said Bluebay’s Macdonald. “There can still be significant capital return.”

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