With the Bank of England base rate down to 2% and poised to go lower, the hunt for a decent income is on. You might be tempted by the juicy-looking yields on preference shares (Prefs) and permanent income-bearing shares (Pibs). Leading Prefs offer net yields above 7.5%, and many of those issued by financial institutions are in double figures. The trouble is, this year has taught investors the hard lesson that risk and reward are correlated assets that looked 'cheap' were priced as such because there was a chance the issuer would go bust. But with the government determined to keep the banks afloat, seemingly at any cost, is now the time to take the plunge?
What are Prefs?
Preference shares are so called because they take preference over ordinary shares for dividend payments. Little wonder, then, that banks that have taken money from the government by issuing Prefs seem anxious to pay them back as soon as possible. Prefs are also ranked higher than ordinary shareholders if a company is liquidated, although they rank below all forms of company debt. Prefs do not usually have voting rights.
Generally, Prefs pay their fixed dividends twice a year. Unlike ordinary dividends the amount does not vary with company profits, something that offers extra protection in hard times. Another point to remember is that most Prefs are cumulative. So if the issuer makes no dividend payments one year, the company is normally obliged to settle its arrears before it can pay an ordinary dividend. Purchases of Prefs, like equities, are subject to 0.5% stamp duty up front. Dividends are taxable and profits are subject to capital-gains tax. The yields on Prefs are normally quoted on a net basis, so to get a fairer comparison with comparable fixed-interest instruments (such as government bonds), you need to gross them up at the standard rate.
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And what about Pibs?
Pibs are building-society shares listed on the London Stock Exchange. Generally, coupons are fixed and are either irredeemable permanent, in effect or may be bought back by the issuer. For example, the Britannia 5.5555% is callable in December 2015. When this bond was originally issued, the building society committed to paying the holder a penal coupon of three-month Libor plus 2%, if it chose not to redeem the bond. When refinancing costs were low it made sense for the building society to redeem these more expensive bonds and so they were valued as if redemption was certain. But in today's environment of low nominal interest rates, yet where the costs of refinancing debt have risen, it may not pay an issuer to redeem Pibs. Indeed, last week Deutsche Bank shocked investors when it became the first big bank to say it would not repay a e1bn bond next month.
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Pib holders are members of the building society with voting rights. But should it be wound up, they rank behind all other lenders and depositors. Interest is also only payable after interest has been paid on ordinary accounts and the payment can still be subject to further restrictions. Ordinary account holders are treated as the priority. The fixed coupon is paid semi-annually, but unpaid interest is non-cumulative. Lastly, unlike Prefs, stamp duty is not payable on Pibs.
How to buy and sell
The relatively liquid stocks issued by large banks and insurance firms are known as 'leaders'. Collins Stewart is the main broker for Prefs and Pibs. "The liquidity of a preference stock is related to the issue size," says Rik Edwards at Collins Stewart. The more liquid Prefs have low bid-offer spreads (of, say, two to three points). Pibs tend to be less liquid and those with the smaller issue sizes suffer wide spreads. Accordingly, to justify the dealing costs, these are instruments that should be held for the long term. Minimum deal sizes in Prefs vary, but can be any number of whole shares. Pibs and subordinated bonds, on the other hand, can be dealt only in round amounts varying from 1,000 shares up to 50,000, depending on the issue.
What are the risks?
The financial crisis has pushed down many Prefs, driving their yields higher. The likes of Aviva and Abbey National offer a yield over long-dated gilts of 426 to 485 basis points (bps a basis point is 0.01%) and bond-comparative yields of nearly 10% and above. Seven years ago, the gilt yield gap was nearer 125bps. The traditionally conservative Co-operative Bank's 9.25% non-cum with a gross yield of 9.79% is worth looking at. Note that investors can't escape tax by putting Prefs in an Isa or Sipp. There are also attractive yields on Pibs with none currently offering a gross yield less than 6.9% and around half offering yields between 8% to 10%. Coventry 6.092% Pibs (CVB) is worth a look, it's callable in 2016 and has a gross yield of 6.92%. The latest figures show the Coventry to be in reasonable financial health. Recent half-year results showed that profits in the first half of 2008 were £35.5m, nearly 8% up on 2007.
If you're interested in this area, these are the two I would go for but there's a big caveat. Be under no illusion: they might rank ahead of equity, but these are risky investments. With more financial upheaval almost certain in the next year, Pibs and Prefs could easily go lower before they recover and the fate of the Bradford & Bingley 11 5/8% Perp Sub Bond provides a cautionary tale. The price has fallen from above 180 in August 2007 to below 20 last month, with the gross yield nearing 50%. As the Government is running down its loan book, the market is assuming the coupon won't be paid. Edwards tells me that no issuer has yet missed a coupon payment on a PIB, but that doesn't mean they won't in the future. So while yields look tempting, I'd stick to putting in money you can afford to lose.
