Investors struggle with Nationwide's equity-like capital deal

* Success (Other OTC: SHGR - news) may hinge on hedge funds and specialist investor appetite

* Aggressive structure to test fixed income boundaries

* Co-op scandal fails to tarnish Nationwide

By Aimee Donnellan and Helene Durand

LONDON, Nov 26 (IFR) - Nationwide Building Society's success in selling one of the most aggressive forms of junior debt yet created will hinge on specialist investors and hedge funds, with traditional buyers struggling to view this as a fixed income instrument.

The UK's largest building society on Monday began marketing the Core Capital Deferred Shares (CCDS), which it hopes will increase its core capital, thereby improving its leverage ratio without compromising its mutual status. Pricing is expected later this week.

The transaction is the latest innovation in bank capital as issuers seek to meet new regulatory requirements. Mutuals, unlike most banks, are unable to issue Additional Tier 1 that can convert into shares as a way of absorbing losses.

But this CCDS instrument is proving to be quite a stretch for some traditional fixed income investors.

"It will be great if Nationwide can sell these things, but from an investor point of view it makes no sense to buy them," said a London-based portfolio manager.

"You are buying these things on trust and the truth is you have as much voting rights by having 1 pound in a Nationwide savings account as you would if you owned GBP100m of these."

Another added he expected the deal to go to specialists and hedge funds. "For us it doesn't look to be an investor-friendly instrument," he said.

NEITHER HERE NOR THERE

Instead, the instruments look very much like equity but don't have the benefit of including voting rights. Meanwhile, unlike Additional Tier 1 deals that have been issued so far, there is no call, making it a truly permanent form of capital.

With no redemption date, Nationwide can only buy them back in the open market. There is no guarantee that the secondary market will be liquid enough for investors to trade the securities as they could equity.

Furthermore, there is no fixed coupon, unlike Additional Tier 1. Instead, it will be payable from distributable items from Nationwide's financial year with a cap at GBP15 per CCDS. The cap will be adjusted for inflation.

"CCDS are effectively equity," said a UK & Ireland-focused DCM (KSE: 024090.KS - news) banker.

"Nationwide has been talking to a real mixture of accounts, some of which will be attracted by the prospect of gaining a 11.5% dividend, while others will be put off by the lack of liquidity."

Nationwide offers no assurances about what happens if it suffers losses. There are no hard-wired triggers, but if the building society runs into trouble which hits profits, for example, the return paid to investors would be reduced, or could even be zero.

The issuer is also quick to point out that ordinary members of the mutual will always take priority over holders of CCDS.

In the past, Nationwide has focused its efforts on selling Permanent Interest Bearing Shares (PIBS) to create core capital.

But under strict new regulations brought in after the financial crisis, PIBS no longer qualify as core capital for UK mutuals.

TOUGH BACKDROP

The deal comes against a tough backdrop for the UK mutual sector, with the troubles of the Co-operative Bank shining an unfavourable light on a business model that was once considered a cornerstone of the country's financial network.

But despite that muddied reputation, Nationwide remains one of the most "investible names", according to a number of accounts, although they say they are only open to more mainstream instruments from the credit.

Lead managers Bank of America Merrill Lynch, Barclays (Other OTC: BCLYF - news) , JP Morgan Cazenove and UBS (Xetra: UB0BL6 - news) have not taken too many chances and have wall-crossed accounts to ensure the success of the transaction.

One portfolio manager said he was still debating whether or not he should buy the notes, but says he is encouraged by Nationwide's reputation as a strong credit.

"The 9.5-11.5% coupon fits in with the average cost of equity in this sector, which makes things a bit more interesting," he said.

London's Mayfair-based hedge funds are expected to hoover up most of the bonds as they offer a similar risk profile to the Additional Tier 1 instrument sold by Spain's Banco Popular Espanol earlier this year.

The building society is aiming to sell as much as GBP500m of CCDS to meet demands from the Prudential Regulatory Authority for a plan to beef up its leverage ratio ahead of the 2019 Basel deadline.

In June, the PRA published results of its capital exercise, highlighting the low leverage ratios of 2.5% at Barclays and 2% at Nationwide. It requires a CET1 leverage ratio of at least 3% by the end of 2015, giving the UK mutual a shortfall of about GBP2bn.

As at 30 September 2013, Nationwide's Common Equity Tier 1 (CET1) ratio (on an end-point Basel III basis) was 11%, one of the strongest ratios amongst major UK institutions.