Stronger yields from stronger societies

Permanent interest bearing shares – a form of bond issued by building societies – underwent an image transformation during the financial crisis: from ‘genteel’ income investments for the retired to risky subordinated debt structures, as issuers such as Northern Rock and Bradford & Bingley had to be rescued from collapse. But bond analysts now argue that their double-digit yields are no longer as risky as they once were.

When the financial crisis exposed bad debt problems at mutual societies as well as banks, holders of permanent interest bearing shares (Pibs) discovered that their steady income streams were not as safe as many had thought. At the time, building societies were be quick to point out that the biggest problems occurred at demutualised former building societies: Northern Rock, Bradford & Bingley and Bristol & West. In the months that followed, however, investors in mutuals’ Pibs found they weren’t immune: the Dunfermline, Chelsea and West Bromwich societies all got into trouble – and holders of West Brom and Newcastle Pibs had changes to the terms of their bonds imposed on them. More recently, Principality Building Society said that instead of redeeming, or buying back, some of its Pibs at face, or ‘par’, value, it would reduce the interest rate paid.

Overall, though, building societies are now looking a lot stronger – as are their Pibs. Thanks to their innovative financing deals, cost controls and quality of lending, their profits have soared. Gross lending by mutuals in the first half of 2011 rose 20 per cent to £10.2 billion. meanwhile, their Pibs still promise yields of 7-11 per cent.

“A conservative investor should bear in mind that a 9-10 per cent yield doesn’t come risk free,” said Rik Edwards, a fixed income specialist at Collins Stewart. “There has been general weakness.” But he adds: “There is no particular worry about the sector. The main concern remains their level of bad debts, but that is dependent on the housing market.”

Societies’ results also suggest that investors need have little cause for concern. In May, Nationwide – the UK’s largest building society – reported that annual profits rose 30 per cent, with bad debts down 35 per cent. Last month, Yorkshire Building Society – the second largest society – increased half year profits by 70 per cent and doubled mortgage lending. Higher 2011 profits have been reported by dozens of other societies, including Coventry, Skipton and Leeds, which make up the top five.

“There is a renewed confidence in the building society sector now, societies want to go out and grab business,” said Adrian Coles, director-general of the Building Societies Association. Kevin Mountford, head of banking at Moneysupermarket.com, says: “They are really coming back with a vengeance.”

Some have shown imaginative ways to reach out for new capital. Kent Reliance tied up a deal with US private equity group JC Flowers which saw it cede control of half of its assets in exchange for a £50m capital expansion. Yorkshire, which had already rescued Chelsea Building Society in 2010 and is in the process of digesting Norwich & Peterborough, last month bought the internet bank Egg for £20 million.

Mutuals still have disadvantages. They may not have to pay dividends to shareholders, but neither do they have shareholders funds to call on in times of crisis. So although the top seven building societies have an average tier one capital ratio of 12.1 per cent – a full point more than the top UK banks – that money is left for contingencies.

Under the latest Basel rules, Pibs are excluded from the definition of core tier one capital because their fixed interest pay-outs cannot easily be cut, as dividends on ordinary shares can. However, the European Union has now offered a new class of hybrid share/bond, the Permanent Loss Absorbing Deferred Shares, designed to meet the needs of mutuals.

Risks and transparency

While the number of building societies has fallen from 100 to 48 since World War II, their conservative business model is little changed. Commercial lending is still limited to a quarter of all advances, and half of all funding must be from customer deposits.

However, mutual societies are criticised for their lack of transparency and democracy.

In the absence of critical oversight, directors’ pay can be as high as that for bankers, as a proportion of the assets they oversee. This has now led to opposition to pay rises at the Skipton Building Society. At Norwich & Peterborough, members angry about money lost through investments in Keydata were denied access to a report that N&P’s own compliance team had issued in 2007, warning about the risks. At West Bromwich Building Society, where bad debts have seen Pibs coupons cut from 6.15 per cent to 1.5 per cent, relatively high executive salaries have been paid.