Mutually exclusive

The outlook for financial markets over the next few years is fairly predictable. We are going to see continued volatility in the equity and bond markets, low interest rates and failing inflation as we readjust from a period of unsustainable growth to one of austerity.

This type of environment makes it very difficult for investors to achieve returns. The Bank of England has started its third round of quantitative easing but with inflation having risen to 5.2 per cent and over 500,000 individual depositors’ fixed three-year deposits reaching the end of their terms, how can this income be replaced?

One little known area of the market which we think is proving very resistant is permanent interest-bearing shares (Pibs).

Pibs are FSA-regulated financial instruments issued by mutual building societies, and are listed on the London Stock Exchange.

A Pibs fund not only gives investors diversification but also solves the liquidity and spread issues in trading, presenting investors with monthly liquidity at net asset value.

The obvious risk is that of a building society failing or defaulting on an interest payment. However, both events are extremely unlikely in view of the history of mutual building societies and the financial stress tests they have recently had to pass.

Unlikely or not, these events are mitigated by a diversified portfolio of Pibs, and that is the reason we only buy Pibs issued by mutual building societies and not banks, such as the Bank of Ireland.

Market risk to the under-lying assets can be mitigated to a certain extent by a tactical hedging strategy taking offsetting positions in gilts or in the FTSE 100 index.

Pibs, by definition, have no call date but some do have an option to call at a future date. Yields are currently running between 7 and 12 per cent.

Pibs offer the ability to obtain a sustainable income from a reliable asset. Even though rating agency Moody’s recently downgraded the debt of a number of building societies, they are generally very well placed to weather the current financial storm.

Their capital ratios are higher then required and they do not get involved to any degree in speculative lending or position taking. They have also all passed the strict capital adequacy requirements imposed by the banking regulator. The value of Pibs is also insulated from the volatility that listed shares experience.

An investment in a portfolio of Pibs achieves the objectives of many investors in this environment, such as an income far higher than can be achieved from cash deposits, plus the relative security that the underlying assets are solid.

There is currently no withholding tax on Pibs’ interest income, no capital gains tax resulting from the sale of Pibs and no stamp duty on the purchase of Pibs.

Nationwide now has seven Pibs issued, totalling just over £1bn against assets of nearly £200bn. Mutual building societies are currently among the strongest financial institutions in the country no mutual society has ever gone into liquidation. This is why we believe that the mutual model is far from broken, Mr Moody.

Paul Gleeson is investment adviser for the Rudolf Wolff building society income fund