Northern Rock - investment income gem?

For most investors these two words fill them with dread. There are those investors who spent time worrying about the safety of their deposits or sometime lifetime investment savings. Those poor investors who have witnessed the value of their investment drop from a high of a little over £12 earlier this year to just over £2 at the present time.

Like all investment ‘car crashes’ there is always a contrarian investment play. With shares in the Rock falling like a stone could there by an income investment gem sitting there waiting to be discovered?

PIBS – investment income opportunity
Northern Rock like many other former building societies issued what were called PIBS. PIBS or Permanent Interest Bearing Securities or Permanent Subordinated loans as they are known where they relate to demutualised building societies such as the Northern Rock. These securities are fixed income investment stocks or loans. They were issued by building societies to raise additional capital. They offer investors a set investment income - the gross coupon price - paid twice yearly, net of basic rate tax. PIBS are traded on the London Stock Exchange, the capital value of Permanent Interest Bearing Shares moves in response to interest rates, as do gilts. If rates rise, the capital value reflected in the buying price falls and vice versa. This in turn determines the gross investment yield PIBS earn. Unlike other loan stock such as gilts there is no redemption date on which the capital is repaid. They are open ended in the respect that these investments can be redeemed by the borrower at any stage or never.

For example
A Coventry Building Society PIBS was issued with a coupon rate of just over 6%, the price of that stock issued at a 100p is trading at 96p meaning that the effective gross yield stands at 6.35%

PIBS risk vs reward
Most PIBS will generate a yield of about 1% above the best deposit rates available at between 6.3 and 7.3%. This reflects that they have to be bought through a stockbroker so that the investor incurs a cost of acquisition and sale and also the fact that there is a small amount of risk associated with them. The risk of these investments is that as a secondary debt, holders of the stock would not benefit from the deposit insurance schemes operated by the Government and also as secondary debt the holders would be the last in line for payout should the former building society ever go bust. The fact that the interest rates are only marginally above the current highest investment deposit rates shows that the investment markets perceives these stocks as very very low risk investments.

The Northern Rock PIBS paradox
This brings me back to the Rock as an investment income play. Northern Rock PIBS at the time of writing stand at 87.5p. The coupon interest rate stands at 12.626% meaning that the gross yield is an eye watering 14.4% before acquisition costs. What are the risks to an investor?
The main risk to a holder of Northern Rock PIBS is that the building society will go bust and there are insufficient funds to pay the holders of the stock and investors end up with nothing. The fact is that the Government, the Bank of England, the UK banking system simply can’t afford this to happen.
The fall out of a major UK bank going bust particularly now the Government has put its ‘neck on the line’ to protect savers deposits would cause a complete political and financial melt down and a crisis of confidence in the UK financial system that would rock the UK’s economy to its foundations. In short – it ‘ain’t’ going to happen. The overwhelming most likely scenario is that Northern Rock will be taken over. In this case there are two likely scenarios

• either the PIBS will be retained in which case investors will continue to receive their bumper investment income payout in perpetuity or until the new owners decide to redeem the loan. At which point the investor would receive the issue price of 100p making a tidy investment profit
  
• the new owners will redeem the stock at the issue price of 100p meaning the investors receive their investment profit early but don’t benefit from the advantages of the ongoing investment income

Less risky investment income PIBS
For those investors with less of an appetite for investment risk then there are PIBS for many of the Building Societies that are not in such ‘financially challenging’ positions as the Northern Rock is. Examples of some investment rates as of 10.12.07 are:

Source: Collins Stewart
Bradford & Bingley coupon 11.625 158p Yield 7.36%
Bank of Ireland coupon 13.375 182 Yield 7.35%
Kent Reliance coupon 7.875 112 Yield 7.03%