PIBs offer stunning yields

Permanent interest-bearing shares (PIBs), LSE-traded securities in building societies, are a much neglected source of income, with yields typically in the 7% to 9% range. As with their cousins, subordinated bonds in former building societies, they have been through a market transformation over the past four years.

Although they are no longer the risk-free widow and orphan investments they were considered to be in the 1980s and 1990s, that is probably for the good. The banking crisis has both clarified risks that were always there and stepped up the rewards for investors savvy enough to assess those risks.

Private investors may still find PIBs tricky to buy and sell. This is because there is little analysis available and online real-time pricing is largely absent too. Trading is thin and spreads can be very wide. Nevertheless, there are ways around all these problems and the lure is a solid investment in a well-capitalised high street name.

The fact that so many are trading well under par not only boosts the running yield (the income investors get from their portfolio as a percentage of the market value of the Pib), but offers the prospect of a solid gain on an eventual redemption.

Some risk history

A look into recent banking crisis history shows what problems can arise with PIBs and subordinated bonds. While over-stretched banks were the principal focus, there were plenty of former building societies that lent too much in the wrong areas and with too little capital.

In March 2009 the government rescued Scotland's largest mutual, Dunfermline Building Society, after property loans went sour. However, state rescues didn't help subordinated bondholders in Bradford & Bingley and Northern Rock when in June 2009 it became clear that coupon payments would be missed.

B&B holders later lost a legal attempt to claim compensation as if they were depositors. Also in 2009, West Bromwich Building Society cut the coupon on its Pib to 1.5% after agreeing a debt-for-equity swap to bail it out of toxic loans.

Throughout the market, thinly-traded PIBs were hit hard as cautious investors exited, and some of the smaller societies' issues became almost impossible to trade. Later, Chelsea Building Society disclosed £41 million of losses in a buy-to-let fraud and £55 million in deposits frozen in Iceland, and then hit Pib holders hard under the terms of a merger with Yorkshire Building Society.

This saw Chelsea Pib holders lose half their capital, and led to the creation of the first contingent capital (CoCo) instrument for a building society. This has been followed with a similar move by Newcastle Building Society, affecting one of its three Pib issues.

Finally, the threat of a total loss for holders of Bristol & West PIBs following the financial troubles of parent Bank of Ireland were finally lifted at the end of 2011, following a campaign by investor Mark Taber on behalf of thousands of fellow investors.

Competition and the economy

A more enduring threat is the slow economic recovery. Some smaller societies, restricted as they are on access to wholesale savings markets, find it hard to attract savers at prevailing rates. They particularly fear loss of business to banks cushioned by close to nil-cost taxpayers' money.

Dealing with better-capitalised rivals is, however, a problem that building societies have long had to deal with. Though they have often been slow to disclose problems, compared to listed banks, they are decidedly more transparent than a decade ago.

New capital rules

So-called Basel III banking regulation does not allow PIBs to be included as 'Core Tier One' capital reserves for a building society, so in the long term PIBs are likely to be redeemed or replaced by capital designed to fulfil this role.

The crucial questions are "how" and "on what terms". PIBs have call dates when the issuer has an option to reset the interest rate. So far only Principality Building Society has opted to reset rather than redeem, and the attraction for it was a very low reset rate of 1.05% over the London Interbank Offered Rate (Libor), which cut the yield to investors by two-thirds, to 2.74%.

That is only going to be really attractive to an issuer so long as Libor remains so low, because the rate has to be reset every quarter. Over the longer term, redemption and then re-issue of securities that do fit with Tier One is much more likely, so investors who pick their PIBs well will get an excellent yield and a (tax-free) capital gain.

Of the issues highlighted in the table above, the Nationwide's are considered the most solid. OneSavings Bank, formerly Kent Reliance, is an interesting issue because it faces the early reset issue head on. Even in the unlikely event that five-year gilt yields are still only 1.05% in mid-2014, the yield is still over 5%, and redemption – still necessary for Tier One considerations – would produce a sky-high return.

The Co-op issue is one that you wouldn't want to be called, because of the over-par price, but it's a perpetual anyway. Finally, the Principality issue is a longer-term take on the reset issue. If the five-year gilt still yields 1% in 2020 I'll eat my hat.

What are PIBs?

Permanent interest bearing shares (PIBs) are LSE-listed shares in current or former building societies, but as they behave more like bonds, it is safer to describe them and subordinated bonds as hybrid capital.

They have a fixed coupon, and do not have a fixed expiry, so can be thought of as perpetuals. However, most PIBs can be redeemed at the issuer's option on fixed dates. Those callable within five years are not eligible for inclusion in an ISA. Generally, the coupon is reset to a floating rate if the call is not exercised.

However, PIBs are not as good as corporate bonds in their security. On a winding up, PIBs holders rank behind all other lenders, depositors and all members holding share accounts. PIBs are non-cumulative, which means that if a coupon is unpaid in a given year, arrears do not mount up.

Interest is paid gross twice a year, and is taxable unless within an Isa, Sipp or similar tax wrapper. PIBs are dealt 'clean', meaning that accrued interest is settled separately, as it is with bonds. No stamp duty is payable on UK issues, and no CGT is payable on gains.

PIBs in the demutualised former building societies have been converted to perpetual subordinated bonds, only differing from PIBs in two ways: firstly, unpaid interest on subordinated bonds is sometimes cumulative, and secondly, these bonds will rank ahead of ordinary shareholders.

With a company having the extra cushion of ordinary share capital and dividends to sacrifice in hard times, subordinated bonds should be safer than PIBs, though events at Bradford & Bingley and Northern Rock didn't turn out that way.

Practicalities of dealing PIBs

Most online systems recognise only a few Pib codes, and cannot retrieve live prices, so a broker willing to take your calls is essential for the serious Pib or subordinated bond investor.

Better still is a broker who has access to the bond platforms of Euroclear, because you can get much narrower spreads than on the London Stock Exchange. Very few are yet available on ORB, the LSE's retail bond platform. These markets are still thin, so don't be in a hurry to deal. Setting a limit can produce good results.

Research on the quality of the issuer is crucial but, in the absence of analyst coverage, it's a DIY job. Credit-rating agencies flag up changes in creditworthiness, but for a real insight a detailed look through the annual report cannot be bettered. It is essential to examine the call dates and reset coupon before any purchase.