High-yield fixed-income oddball looking increasingly anachronistic
Sooner or later, the investor trawling the markets for a fixed-income security which also offers a yield beyond the virtually undetectable will be drawn to PIBS – Permanent Interest Bearing Shares. They’ve been in play since the late 1980s and in the news in recent months, especially apropos the Co-operative Bank and the Nationwide Building Society, and it’s been news which illustrates the particular risks attaching to these otherwise seemingly attractive investments. We lift the lid on PIBS and discover an oddity reaching a use-by date.
First up, what exactly is a PIBS? For starters, we can observe that despite the name it’s not a share at all. An allied observation is that the ‘permanence’ of that inviting interest rate can no longer be taken for granted. Let’s delve deeper.
PIBS are a creature of, and solely of, mutual societies – building societies and co-operative societies, especially for our purposes, banks. The point about such entities is that they don’t have share capital in the conventional sense. Rather they are structured as clubs, like sports clubs if you like (indeed, like FC Barcelona amongst others), with members collectively holding an interest in the society’s distributable net assets, should they ever become available for distribution (ie, in a liquidation), but not as units of share capital listed and traded on stock exchanges.
The Mutual Point of Difference
Of course, there are securities issued by mutual societies which are traded on stock exchanges and which have some resemblance to shares but crucially, unlike share capital, those units don’t carry a say in the running of the society commensurate with the size of the holding. In a mutual, each member has a single vote, regardless of that member’s financial stake in the organization. This hallmark of the co-op is its most prominent point of difference from a proprietary company, in which the amount of share capital owned is directly related to the degree of say in the company’s management.
A related point here is that mutuals can’t raise fresh capital, either for expansion of their enterprise or to plug a shortfall, by issuing shares, either to existing holders as a rights issues or to new subscribers. What they can, indeed must, do beyond reserving as opposed to distributing profits is borrow. And if you’re a co-operatively organized bank, of course, one way to borrow is to attract deposits, by offering enticing rates of interest.
Wheeling in the PIBS
But in what nowadays looks like the free-wheeling 1990s, the debt instrument of choice for building societies and banking co-ops in the UK wasn’t an on-call savings account but the PIBS. They were issued and taken up in abundance, first and foremost because of the very attractive interest rates on offer but also because of the high regard in which co-operatively organized enterprises were held.
At, or at least very near, the high-water mark were the 13% PIBS issued by the Britannia Building Society (but since 2009 adopted by the Co-op Bank, so that’s what we’ll call them). As was typical, these securities were issued with no redemption date (making them to this extent at least ‘share-like’) but with the Co-op reserving an option to ‘call’ for their redemption after a specified number of years. Whilst many PIBS issues were confined to institutional placements, others like the Co-op’s 13% found their way onto the secondary market and into the eager hands of retail investors, of whom many were either retired or in close proximity and drawn to market-beating yields from companies – like the Co-op and its predecessors– which had a history of solid growth and stability.
Chickens Home, Boom Lowered
So it was for a number of years, with the coupon being faithfully serviced and those 13% PIBS trading in the secondary market at prices which maintained yields at a very acceptable 8-9 percent. Until May this year, when the many chickens in the Co-op’s ill-fated acquisition of Britannia back in 2009 finally came home to roost and a gaping billion-pound hole in the Co-op’s balance sheet caused Moody’s to downgrade the venerable institution’s PIBS to junk bond status.
From a going price of 160 pence on the pound prior to that action, the 13% notes had plummeted to 60 pence by early July, at which point the Prudential Regulation Authority – newly-minted watchdog to the UK’s banking sector – lowered the boom. On 12 July, the people’s bank found itself in the unedifying position of having to announce that the PRA had vetoed the scheduled 31 July interest payment. In a terse statement, Co-op Bank management advised:
Therefore, the interest payment on the 13% Bonds scheduled for 31 July 2013 will be deferred and will be paid at the time of, but conditional on, the successful completion of the Exchange Offer.’
‘P’ in PIBS not so permanent
That reference to the Co-op Bank’s ‘Exchange Offer’ points to a singular risk for PIBS holders. In given circumstances – such as a liquidity squeeze on the issuer – they can effectively be cancelled, either under the terms of issue or under law at the behest of banking regulators (though this is being challenged in the Co-op case), and substituted with something else. That exchange product could be proprietary shares – as with a demutualization of the issuer – or something called Core Capital Deferred Shares. This is the moniker attaching to the instrument with which the Nationwide Building Society – the UK’s and the world’s biggest – is intending to replace its PIBS, following member approval of the action at the last annual meeting.
Basel III bumps PIBS
No-one is suggesting that Nationwide is in dire straits fiscally speaking. And/or that it is having difficulty servicing its several PIBS issues as the biannual interest payment dates roll around. To be sure though, the PRA is in a nervous state and also in July, after confronting the situation at the Co-op, ordained that Nationwide must increase its ‘buffer’ against losses by £2 billion by the end of 2015. Given that the society has been netting about £200 million a year in recent times, and with no sign as yet of higher interest rates out of the Bank of England, that target’s not going to be met from retained earnings alone. And neither will PIBS any longer do the trick, because under the Basel III rules for bank capital adequacy such debt will no longer qualify as ‘Tier 1 core capital’. No new PIBS, or PIBS-like creatures, will be countenanced and those in existence must be phased out over the next eight or so years with something that will qualify.
PIBS v CCDS – It’s the little differences
Such as the CCDS, above-mentioned. How exactly does it differ from a PIBS? In particular, will it be a form of equity whereas PIBS are nothing but unsecured and subordinated debt? And how can a building society anyway issue shares?
In a ‘PIBS Q&A’ on its website, Nationwide has this to say:
PIBS are not the same as ‘ordinary’ shares in a listed company. Ordinary shares confer an equity stake in the company itself whereas PIBS are more like a bond, which is a promise in writing to repay a debt. PIBS generally pay a fixed rate of interest to the holders …
Which, according to the separate Q&A which Nationwide posted to its website ahead of last year’s AGM, is more or less what could be said of CCDS’. Consider this:
Depending on Nationwide’s performance over a financial year, the directors would have discretion to use a percentage of profits earned over that year to pay a distribution to holders of Core Capital Deferred Shares.
To protect the Society’s overall reserves, the distribution amount will be subject to a cap (or limit) of £15 per share which will be written into the Society’s rules. The cap has been set to an assumed first issue price of £100 per share.
In the next sentence, it’s explained that this 15 percent yield will then be inflation-adjusted from time to time.
So seemingly the CCDS is to be a ‘share’ – read, acknowledgement of indebtedness – whose only meaningful difference from a PIBS is that the interest rate will max out at 15 percent as opposed to being fixed at 15 percent. If Nationwide has a spectacular year, CCDS holders must remain content with 15 percent and if it ‘were in a period of reduced profits’, in the words of the Q&A, its management ‘anticipate that the return paid to investors would be reduced, or could be zero’.
Much hangs on Management
It is presumably this flexibility for Nationwide’s management to tinker with the actual yield below the maximum payable which elevates the CCDS to the status of Basel III ‘Tier 1 core capital’ whereas the PIBS is compromised by the fixed interest rate struck at point of issue. In as many words, returns on CCDS’ are to function like dividend on shares – the real ones –with no cast-iron guarantee that the CCDS holder will get anything at all in difficult times.
Nationwide has yet to actually launch a CCDS offer and there continues to be a thundering silence from the Co-op Bank as to what ‘the Exchange Offer’ will provide its 13% PIBS-holders, though in the circumstances there is bound to be some form of haircut.
Co-op 13% PIBS dead in water?
Until some light is shed, an investment in PIBS – and especially in a Co-op PIBS, it must be said – is not for the risk-averse. Even the pundits get it wrong. Back in May, after the Moody’s write-down, The Telegraph quoted a Canaccord Genuity broker, one Rik Edwards, as fancying the Co-op 13% PIBS. They were doing better in the market than the later 9.25% issue, with the post-rating write-down price producing a yield of 16.25 percent versus 12.8 percent for the 9.25% notes. Now of course, since deferral of the July interest payment and with the continuing uncertainty as to what will replace them, you would be hard-pressed to quit Co-op 13% PIBS for any money.
According to a commentary in investorchronicle.co.uk of 27 September, headlined ‘Un-Co-operative’, those PIBS were issued to retail investors by the then Britannia Building Society way back in 1992, netting £110 million (roughly double that in today’s money). Many continue to be held by the original purchasers, who are now elderly and reliant on an income stream which since July this year has become a decidedly unknown – and for now unpaid – quantity. Assuming that the Co-op Bank is not contemplating shutting its doors and filing for bankruptcy – a nearly unthinkable prospect, something is undoubtedly being hatched in Balloon Street, Manchester to replace those PIBS, in all probability with inputs from hedge funds not renowned for largesse towards the needy. But as noted earlier, whatever is being cooked up, ‘the Exchange Offer’ will almost certainly involve a significant reduction in any future interest charge, with the bank and its owner, Co-operative Group Ltd, claiming there isn’t the money otherwise available to meet the PRA’s demand for a £1.5 billion capital top-up.
Ditto PIBS generally
Regardless of that outcome, the writing is on the wall for PIBS. They hearken from a different era, when High Street banks and building societies were safe as houses and there’d been no Northern Rock, no Global Financial Crisis and no ‘peripheral Eurozone’ bailouts. The only reason they remain in the market is because the issuing building societies and co-ops have lacked sufficient incentive to retire them. With interest rates at or near zero percent, the prospects are slim of a replacement product’s uptake, certainly at the retail level.
But now PIBS have got to go in any event. Not this year or next, but within a known and fixed time-frame. Given the continuing question-mark as to what will replace them, there’s a lot to be said for looking elsewhere for a stable, fixed-income investment. Even if it won’t get you 16.25 percent.