How risky are PIBs if interest rates rise?

Permanent interest bearing shares (PIBs) from building societies offer attractive rates of interest, but, as Bradford & Bingley investors found to their cost, they are not risk free. The prospect of interest rate rises could hit their prices. Is this a problem?

Impact of a rate rise

Savers will be watching to see if the Bank of England Monetary Policy Committee puts up interest rates when it meets on Thursday. Those with money on deposit will be hoping for  a better return – unless the banks and building societies simply increase their profit margins, raise mortgage rates and leave savings rates more or less where they are.

But fixed interest investors holding gilts and bonds face a fall in the value of their investments. While the coupons they receive will remain the same, the actual price of the bond or gilt will fall to reflect the rise in yields for money on deposit and bonds.

What are PIBs?

Holders of PIBs (permanent interest bearing shares) issued by building societies face a particular dilemma. Unlike some other issuers of fixed interest securities, the building societies which issue PIBs are uniquely affected by interest rate changes. With mortgage rates currently at an all-time low, they are likely to suffer rising defaults and arrears as interest rates rise, potentially affecting cash flow and making it more difficult for the building society to raise money in the markets.

PIBs which are ‘subordinated’ debt would be the first to suffer if there were any problems – as holders of Bradford & Bingley PIBs found out very painfully. Is there any danger that rising interest rates will force building societies to cut PIBs payments?

PIBs are past the worst

‘It appears that building societies are past the hump, as are some of the banks,’ says Mark Glowery, bond expert at Stockcube which monitors and analyses fixed interest securities. ‘I am not aware of any payments on PIBs under threat. It is quite a long step from rising interest rates to withholding payment on PIBs.’

David Channon who runs a Luxembourg-based PIBs fund at Guardian Managers takes a similar view. ‘I don’t think there is any danger of PIBs defaulting. We have had all the problems already with Bradford & Bingley and Northern Rock. Those societies which are left are the ones where their capital ratios are so much stronger. I don’t think you will see any more defaults like Northern Rock or B&B.’

Societies offering PIBs

Nationwide is by far the largest issuer of PIBs. ‘Nationwide’s PIBs are rated BBB which is investment grade,’ says Richard Barnes of ratings agency Standard & Poor’s. ‘In the past building societies have only defaulted on their PIBs when they have been in breach of regulatory capital requirements. In the case of Nationwide, that is not something we see as likely.’

Newcastle, Nottingham, Coventry, Leeds, Manchester and other building societies all have PIBs traded in the market but they are not rated by S&P. But you can get a rough idea of what the market thinks of other societies PIBs, relative to Nationwide, by looking at the current yields. Nationwide issues are priced at a gross yield of 6.74% to 7.89% (not counting the floating rate issue which is linked to Libor).

Clearly, as it is by far the largest building society, Nationwide is likely to be one of the safest. Yields from other societies range from a similar 7.2% at Yorkshire building society, the second largest after Nationwide, to 9.22% at Leeds and 9.79% at Newcastle. Not all of the differential is down to relative strength and security – some reflects the different terms of the PIBs issues. But it gives us a rough benchmark.

Look at the income

Rising interest rates and falling PIBs prices are not necessarily a problem. It is the fear of a default on PIBs payments that is the worry. Many people invest in PIBs to provide income in retirement. They are quite prepared to sit out the interest rate cycle until interest rates fall again and price rises. As long-term investors they bought at a specific yield and are mainly interested in the income which will remain constant at the level at which they purchased the bond. Any capital gain is a bonus and any capital loss is something their beneficiaries will have to deal with.

Should we be worried then? Mark Glowrey spends all his time looking at bonds and if he isn’t worried, then we probably shouldn’t be either. He makes an important point too that the regulators don’t make life easy for small investors. ‘The European Prospectus Directive restricts senior bond sales to a minimum investment of £50,000 which is too large for most private investors. This means that small investors only have access to the highly subordinated bonds such as PIBs.’ In other words, we don’t get a look in at the safer bonds.