Two unusual sources of investment income

I enjoy my job. But I don’t want to be doing it forever. I suspect you feel the same way about yours.

The point of investing for most of us is to build a pot that’s big enough to generate a regular income that will cover our living costs, so that we can retire in comfort.

And income is also a really important part of building the pot in the first place. One of the best ways to grow your savings is through the wonders of compounding. Reinvesting income from your existing investments is a vital part of getting a decent return on your savings.

The trouble is, income seekers have a tough job on their hands just now. The government and the Bank of England don’t want us to save. Instead, they want us to spend in the hope that this will make the economy grow. This is why traditional sources of income such as savings accounts and government bonds pay such low rates of interest.

As investors have been driven out of traditional income investments, demand for other, riskier income assets – such as corporate bonds (company IOUs) and shares that pay big, safe dividends – has risen.

This has driven up the price of these assets. In turn, this means that new buyers won’t get very high levels of income from them – in other words, the yields have gone down a lot.

So where can you go for higher rates of income on your savings? Today we’ll talk about two possible alternatives, and their advantages and pitfalls.

Permanent interest bearing shares (Pibs)

Pibs are issued by building societies and are listed on the stock exchange. They can be bought and sold through a stockbroker just like shares. Pibs tend to offer much higher rates of interest than most bonds or shares.

So what should you be aware of before you consider buying?

First things first: although Pibs are issued by building societies they are not like savings accounts. If the building society goes bust, you are pretty much at the back of the queue when it comes to getting your money back – only the shareholders will be behind you. You cannot get your money back from the Financial Services Compensation Scheme (FSCS) as you can with savings accounts.

So never forget – this is a risk asset, just like a share or a bond. So how does it work?

Most Pibs offer to pay a fixed rate of interest forever. However, unlike bonds, there isn’t usually a date when they promise to give you your money back (a maturity date).

The interest payments on Pibs are paid gross (before tax is taken off), which means you may have a tax bill to pay unless you hold them in a tax-efficient account such as an Individual Savings Account (Isa) or Self-Invested Personal Pension (Sipp).

Also, if the building society misses an interest payment, it does not have to pay you more in future years. In investing language, this means the interest payments are not cumulative.

Some Pibs do have an optional buyback date. But you need to be careful if you buy one of these. That’s because the building society may only pay back a ‘par’ or ‘face’ value (usually £100 per Pibs).

If you pay more than this par value for the Pibs, you could lose money if the issuer decides to buy them back. Even if it doesn’t, it may have the option of paying a lower interest rate after the optional buyback date.

Another thing to watch out for if you decide to buy is that the difference between the buying and selling price of Pibs (known as the bid-offer spread) can be quite large. When looking at the interest rate you are getting, always remember to base it on the buying (offer) price.

Preference shares

Many private investors have never heard of preference shares (or ‘prefs’). They are a special type of share issued by some companies.

A preference share is so called because you get preferential treatment compared with ordinary shareholders. You get paid your dividends before them; and if the company goes bust, you will get your share of any money left before the ordinary shareholders do.

It’s worth remembering that a preference share dividend is paid out of a company’s post-tax profits and is usually fixed. If the company grows its profits, your dividend will not increase; it will remain the same. In some ways, this makes it more like owning a bond than a share. But your investment is less risky than a normal share.

A company cannot pay a dividend to ordinary shareholders unless the preference dividend has been paid first. And in the case of a cumulative preference share, if any year’s dividend payments are missed, then they must all be paid before any dividends are paid to ordinary shareholders.

There aren’t many preference shares available. But you can buy them easily through your stockbroker. Some of the dividends can be quite high and relatively safe, as they only require a small amount of the company’s profits to pay them (there are fewer preference shareholders, so the overall payout is much lower than the ordinary dividend). It can often be a better – and safer – strategy to buy the preference shares of companies such as banks or insurance companies, where the ordinary dividends could be less secure.

Again, as with Pibs, there can be big differences between the buying and selling price of the share. Always calculate the income return you are getting by dividing the dividend you receive by the price you will have to pay.

Also, find out whether the company has the option to buy back the preference share. This is the case with redeemable preference shares. It can also be a good idea to avoid the preference shares of companies with too much debt.

• This article is taken from our beginner’s guide to investing, MoneyWeek Basics. Everything you need to know about how to invest your money for profit, delivered FREE to your inbox, twice a week. Sign up to MoneyWeek Basics here