Un-Co-operative

The bank intends to raise £1bn through the move, part of the £1.5bn it needs to raise to fill the hole in its balance sheet caused primarily by loan losses at the Britannia Building Society with which it merged in 2009. Junior bondholders will be offered new ordinary shares in the bank. The rest of the money is to come largely from asset sales and a bond issue by the parent Co-operative Group.

No response to calls for dialogue

Details of the bail-in are due to be detailed in October, but there has been no substantive response by the Co-op either to pressure from bondholder campaigner Mark Taber, representing small investors, or to proposals put forward by a group of institutional holders led by Aurelius Capital Management which would see bondholders assume control of the troubled lender.

"The reality is that the market price reflects [expected losses from] the bail-in. I don't see a better option than just holding on to see what the Co-op does," said Daniel Reynolds, manager of the Guardian Permanent Income Fund, the only fund to specialise in building society debt.

For now, there are no coupon payments on bonds and, given the financial hole the Co-op Bank is in, there are unlikely to be any dividends from the new ordinary shares either. It isn't an edifying prospect for small investors in the bonds, many of whom are elderly and rely on the substantial income they used to generate.

"Prices in the market are quite distressed," Mr Taber said. "The question is whether the Co-op can do more, whether the regulator is doing all it can and whether the capital requirement imposed on the Co-op bank is excessive," he added.

The benefits of making a complaint

In the meantime, there is much that investors can do, now that the issue has finally caught the attention of regulators and the media. "Small investors do have power. They need to make a fuss, write letters, contact their MPs. It does all have an effect," Mr Taber said.

The value of many of the bonds remains under half what they were worth before the news broke in May that the Co-op's bonds had been downgraded to 'junk' status by credit reference agency Moody's. Holders did have some advance warning of the bank's problems when the Financial Times drew attention to a £1.5bn hole in its capital in February.

Mr Taber noted that getting the £1bn of capital via an exchange issue for the £1.25bn of bonds and preference shares wouldn't be easy. "They need a high participation rate, which means the offer must be attractive. But it is hard to see how that can be structured."

The uncertainty makes it hard to see whether it is worth a speculative purchase of the bonds or Pibs in the hope that the Co-op decides on a less punitive bail-in. The fact remains that the mutual has to find the money from somewhere, and the parent group is already selling insurance operations and other assets to part-fund the capital that the regulator says it needs.

Sector-wide issues

The developments are particularly troubling for the mutual sector because of the Co-op's ethical and customer-friendly reputation, which had made it a symbol of the alternative approach to banking. Anecdotal evidence is now emerging of investors treating Pibs just like high-interest savings accounts.

"It has done a lot of damage to the sector because there was a lot of belief in the Co-op and in mutuality," Mr Reynolds said. Mr Taber agreed. He noted that many people hadn't diversified their holdings, and some had all their holdings in Co-op bonds and Pibs. "It was because it was the Co-op, and because they were trusted." Certainly, the Co-op's tardiness about recognising problem loans after its takeover of the Britannia Building Society in 2009, its continued attempts to buy 617 branches from Lloyds and its wasting of over £250m on computer systems showed management was out of its depth. Moreover, as a slap in the face for those who believed in its ethics, it is worth noting that the bank mis-sold payment protection insurance, interest rate swaps and identity theft products to consumers, albeit on a modest scale.

For investors across the wider Pibs sector, this has been a timely reminder that the risks to any mutual is in theory as great as to any investor in bank shares. While building societies and mutuals may never have been as incentivised to adopt risky lending, the fact that they do not have ordinary shareholders to soak up losses leaves Pib and bondholders with one less safety cushion between them and losses, should things go wrong.

Attractions remain

Nevertheless, for investors who are willing to take some risk, and who diversify holdings within the sector, depressed prices offer some income attractions. Gross yields in the sector vary between 6-10 per cent. Moreover, after the Nationwide’s decision to buy back some of its Pibs there is a good chance of investors being able to make some extra profit on exit. With Pibs no longer classed as suitable for Tier 1 capital, other mutuals will have to decide how to redeem them.

And while fears of eventual Fed ‘tapering’ of quantitative easing rumble on, those who worried about reset rates for Pibs have less reason to fear. While many issues with call dates in the next two to three years had been depressed, higher interest rates make reset rates both less attractive to issuers and less onerous for holders.

With all resets being at a margin over Libor or five-year gilts, the higher interest rates go, the less temptation issuers will have to reset rather than redeeming bonds at par. So while rising rates are bad for most bonds, there is a silver lining for holders of Pibs and similar issues.

Existing UK bank and building society Pibs & subordinated bonds