Value in PIBS despite rise in prices

The hunt for value and yield has boosted returns in permanent interest bearing shares (PIBS) recently, but for those looking for yields in the 6-9% range who are prepared to do their own research, there is still value left.

PIBS are high-yielding hybrid bonds issued by building societies. Those societies that demutualised turned their PIBS into subordinated bonds in the demutualised lenders. The sector was given a bad name by the collapse of Northern Rock and Bradford & Bingley among others, but the overwhelming majority of issues - particularly among PIBS - have proved safe.

"There is an increasing appreciation of building societies and their safety," says Daniel Reynolds, manager of the Guardian Permanent Income Fund*, the only fund to specialise in building society debt.

The key thing investors must appreciate is that in return for the unusual combination of high yield and safety, they have to overcome wide spreads on dealing, and a general lack of liquidity in the market. This is a buy and hold, not a trader's, market.

"The reality is that you will be investing for a long time, so you should invest on the strength of the balance sheet of the lender," Reynolds says.

"I think prices have reached a sensible level," says Mark Taber, a professional bond investor who runs a website for private fixed-income investors. "You still get a reasonable yield, just don't expect much capital appreciation now."

Both types of capital may be endangered in future, which is giving extra lift to prices. The capital rules for building societies under Basel III international banking rules will not ultimately allow these instruments to be counted as core capital.

New classes of capital, often a form of contingent convertibles, have begun to emerge, which are triggered if minimum levels of capital cover are breached. Such capital is designed to be drawn on by the building society to meet losses, which will allow these issues to count towards Tier One capital under the Basel rules.

The current crop of PIBS, though theoretically available to be wiped out to meet capital losses, are not designated Tier One, so will look more attractive to those seeking safe income as the newly designed contingent securities emerge. That will be particularly true if a society decides to issue the new capital without retiring the existing PIBS. Holders of PIBS, senior to the new issue, will benefit from a new buffer against loss.

Practicalities

PIBS or subordinated shares can in theory be bought through any stockbroker, though few online systems have all the stock codes required. Telephone dealing may be necessary, but in some cases spreads may be unreasonably wide. Some stockbrokers are members of Euroclear, and do not have to deal via the LSE. They can get narrower spreads. An embryonic bulletin board, FIOB, is worth a look as a way to connect retail buyers and sellers. In the meantime, keeping to the more liquid issues saves time and money.

That said, an additional complexity for investors looking to buy into both classes of bonds is the issuer's option to call (repay) an issue early. In the past almost all calls were exercised, and the principal repaid at par, under a gentleman's agreement, but some issuers now face an incredibly tempting reset rate, based on current low Libor or gilt yields, which could slash their cost of capital.

Principality Building Society went down this route in 2011 with its 5.375% PIBS. This had a reset rate of just 1.05 points over Libor, slashing the running yield from around 8% to just 1.69% currently, where it now trades as a miserable floating rate note. Yorkshire Building Society, the Co-operative Bank and Nationwide have gone down another route, launching tender offers in the tail-end of 2012 for issues close to call dates. While these tenders were below par, they were also both above the prevailing market price. Nationwide followed up with a reset, and the others might yet do so, but the tender gives holders a profitable exit route for investors. As a result, prices in the sector have firmed. "I think the worry about resets is overblown," Reynolds says.

For potential investors, the way to handle this is to identify issues that have call dates well into the future, giving Libor or gilt benchmarks time to revert to more normal levels, or find issues where the reset rates are comfortable. For example, a number of PIBS have reset rates of five-year gilts plus 400 basis points, which even at current rates would translate to a coupon of 5%. As another option, true perpetuals eliminate all reset risk. "I do like the non-callable issues," says Taber. "They have better yields."

Some issues trade over par, which indicates a capital loss for holders if there was ever a redemption. That is unlikely for true perpetuals, such as the Co-operative Bank 13% issue. However, there are some other issues - which for this reason are not included in the table above - where prices are over par because of the generous yield, but there is a distinct possibility of repayment on the call date, including a couple of issues from Nationwide. This brings the dilemma of a modest capital loss at call, or a reset rate less generous than the current running yield. The choice is not for the investor to make, but the issuer. So, while PIBS and subordinated bonds are still attractive for yield seekers, choosing the right issue is essential.

*Guardian Permanent Income Fund was set up in September 2009, has a 1.5% management fee, up to 5% upfront fee, and a 20% performance fee on returns over 7%. It is Luxembourg-listed, and the minimum investment is the sterling equivalent of €125,000 (£108,200). The total expense ratio is 2%.

What are PIBS and subordinated bonds?

PIBS are LSE-listed shares, closer in nature to hybrid bonds than shares, except for their security. On a winding up, PIBS holders rank behind all other lenders, depositors, and all members holding share accounts. PIBS are non-cumulative, so unpaid coupons do not have to be made up. Unlike subordinated bonds, there are no ordinary shareholders to be asked to make up any capital shortfall first. However, tough rules on deposit sourcing and lending restrictions for building societies makes it less likely that any society will end up being the next Northern Rock.

Interest on PIBS is paid gross twice a year, and is taxable unless within an ISA, self-invested personal pension (SIPP) or similar tax wrapper. PIBS are dealt "clean", accrued interest settled separately, as it is with bonds. No stamp duty is payable on UK issues, and no capital gains tax is payable on gains. A few issues can only be dealt in large minimum volumes (known as "minimum piece") of £50,000 to £100,000 nominal.

Like bonds, PIBS have a fixed coupon, and unlike most bonds, do not generally have a fixed expiry. Those callable within five years are not eligible for inclusion in an ISA. Any PIBS can be put in a SIPP.

Subordinated bonds are very similar in most aspects to PIBS. The only real difference is that in most cases, subordinated bonds have slightly better security than PIBS because most issuers have ordinary shareholders who are first in line to be called on in the case of a capital shortfall.

"There are hundreds of subordinated bonds," says Taber. "However, the high minimum price for dealing in them puts the vast majority outside the reach of retail investors."

There are plenty of historical names on issuers too. Cheltenham & Gloucester has an 11-3/4% perpetual subordinated bond, with a high minimum of £50,000, that is effectively a bet on the balance sheet of Lloyds Banking Group (LLOY), its ultimate parent. Ulster Bank's subordinated bonds, also 11-3/4%, and sporting an eye-catching yield of 10%, would fall to its parent company Royal Bank of Scotland (RBS). Moreover, because of its domicle there is a withholding tax attached that can be tricky to reclaim, according to Taber.

Some, like the two classes of subordinated bonds in OneSavings Bank, have no public shareholders. OneSavings, a joint venture between Kent Reliance Building Society and investment boutique JC Flowers, is effectively a private equity firm.