Investing in Pibs

In investment terms, however, 'permanent' capital signifies debt, which means interest paid gross. Perpetual just signifies something that that lasts without any obvious limit. So while a 'perpetual callable tier one note' might seem like a form of debt, it is in fact a preference share. But a 'permanent interest-bearing share', or Pibs, which might seem like a share, is to all intents and purposes a bond (see for more on investing in bonds)

The origins of Pibs

Pibs originated as a way of allowing building societies to tap into funds from stock market investors. They pay a fixed rate of interest. They have no formal repayment date, although some can be redeemed at the issuer's option at or after a specific future date and generally switch to a floating interest rate if not 'called' in this way. Their 'undated' nature means they tend to fluctuate in price rather like an irredeemable gilt-edge stock, more sensitive than many other bond-style investments to movements in long term interest rates. But, prices of Pibs also reflect the perceived credit quality of the issuer.

A wide range of building societies have issued Pibs in the past, including many that have since demutualised and become banks, and then subsequently been brought into public ownership as a result of the impact of the credit crunch. So, while investors never used to question the safety of Pibs and they typically stood on yields a couple of percentage points above those of undated gilts, since the credit crunch yields on many Pibs have risen to much higher levels.

Pibs pecking order

This is because the credit crunch has highlighted their big drawback as an investment. If an issuer hits rocky times, the holders of the Pibs typically rank among the lowest of the low in the pecking order for repayment when a business gets into financial difficulties.

A glance at the terms of typical Pibs shows the extent of the problem. Pibs holders rank behind all other creditors in respect of repayment of principal and interest, and in the case of mutual building societies behind the claims of members holding shares (ie depositors). This so-called 'subordination' is the reason for the high yields.

Moreover, Pibs are not protected by any investor or depositor compensation schemes.

If a building society suffers a 'run' on its deposits or goes bust, depositors who can't or don't get their money out receive compensation of up to £50,000. But Pibs holders would not be compensated in these, or indeed any other circumstances. Similarly if capital ratios fall below certain levels, interest payments on Pibs could be missed and, since interest is non-cumulative, it doesn't roll up to be paid at a later date. A missed payment is a missed payment.

Source: Collins Stewart; annual reports

Daily prices and data on key Pibs are available here...

A glance at the table shows the scale of the yields on offer. The table excludes all Pibs that have a minimum dealing size of more than £1,000 nominal. Most Pibs conform to this but some require investment of a minimum of £50,000 nominal and some amounts of between £2,500 and £10,000. Some issues are thinly traded.

Virtually all Pibs pay interest twice yearly. The 'yield to call' column shows the yield assuming the stock is called (ie repaid at par) on the date indicated. Prices are quoted net of accrued interest and are free of stamp duty. Interest is paid gross, which means that Pibs are attractive for those who are zero rate taxpayers or those who have some means of sheltering the gross payment. Importantly, perhaps in the current climate, they are treated in the same way as corporate bonds, and free of capital gains tax.

Mutuality rules

What the table shows is the reverse of what used to be the case. Before the Northern Rock debacle and the crisis of confidence in many quoted banks and financial institutions, yields on Pibs issued by old-style mutual building societies tended to be at a premium to those from the likes of Halifax, Bradford & Bingley and Northern Rock.

Now mutuals (marked with an asterisk in the table) are seen as the safer alternative, because they have traditionally got the majority of their funds from depositors rather than from wholesale money markets. As the table shows, mutual societies like Britannia (where a merger with Cooperative Financial Services is under way), Coventry, Kent Reliance, Manchester and Skipton typically get between a fifth and a third of their funding from the money markets. In Northern Rock's case, prior to collapse, the figure was 75 per cent, and in Bradford & Bingley's it was 50 per cent.

Those institutions now in public ownership - like Northern Rock, Bradford & Bingley, and Bank of Ireland - stand on yields ranging from 17 per cent to 66 per cent. Even Pibs issued by Halifax, now part of Lloyds Banking Group and 44 per cent owned by the government, stand on yields well into double figures. It's worth pointing out that so far no PIB issued by a building society or bank has ever missed a payment of interest or repayment of capital. Although there is always a first time.

In the case of mutual building societies, one additional key factor is that confidence can't be affected by a plummeting share price, and depositors aren't likely to be spooked by a seizing up in the wider credit markets. Without a share quote, a small building society could, if the worst came to the worst, be quietly rescued without contravening the technicalities of share trading rules that prevented this happening to Northern Rock.

The yield attractions of Pibs are now substantial, particularly those of the remaining smaller mutual societies and especially those with relatively low reliance on wholesale funding.

But the yields on these 'safer' stocks show that the market expects further twists and turns in the credit crunch 'plot'. There is plenty of speculation that smaller building societies may be forced into mergers with larger mutual players like Nationwide, and some of these moves have already happened.

That's not to say that these stocks are for widows and orphans, which was arguably how they once used to be viewed. Nor are they stocks on which to 'bet the ranch'. But as a way of getting extra income into your portfolio in a reasonably secure way, with the potential of a tax free capital gain if the premium over gilts begins to narrow, they have definite attractions.