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In lieu of redeeming features

24 Nov 2012 SYDNEY MORNING HERALD
BY SHARE ANALYSIS AND ADVICE BY NATHAN BELL


Unfavourable reviews on preference share offers like ANZ CPS3 and Suncorp CPS2, or subordinated notes such as Colonial Group's, always get the phones running hot.

Nothing rankles brokers and investor-relations staff quite so much as our refrain that the 10-year, 20-year or 50-year official terms on these securities might actually be 10 years, 20 years or 50 years. Or, that perpetual might actually mean forever, or thereabouts.

"No chance," they argue.

"Never happens."

The "reputational risk" of not redeeming at the first opportunity (usually five years in) was the point we were missing, they argue.

Last week, Bank of Queensland settled it.

The Australian banking sector isn't stressed, yet BOQ has already broken the unwritten contract on which the brokers and flacks made their pitch.

In the bank's own words: "BOQ has determined not to redeem PEPS (the 2007 issued Perpetual Equity Preference Shares) on the first optional call date of 17 December, 2012."

This means the securities won't be redeemed next month and investors won't get their money back as many might have expected.

"Reputational risk" was always a non-core promise. Now everyone knows it. BOQ won't be the last to pass up on early redemption, either.

Not only does the non-redemption leave many PEPS owners with a security they don't want to hold past year's end, they have also being encouraged to swap their existing investment for a new security, without being offered a cash alternative.

PEPS aren't Basel III compliant. Compared with the new generation of bank preference shares, they're not quite as good at absorbing losses on behalf of the bank in the event of an emergency.

So PEPS holders get the "opportunity" to switch into a new, higher-yielding instrument - BOQ Convertible Preference Shares (CPS) - under a "reinvestment offer". There is no cash alternative: either take the CPS or continue holding PEPS.

The CPS offer a higher interest rate but, in accordance with Basel III rules, have more fine print stacked against owners. That makes them somewhat riskier. Intelligent investors might argue over which security is superior.

But to call this an offer is a stretch. Here's what an offer would look like: give PEPS owners their $100 back in cash, and then ask them if they would like to reinvest any of it in CPS. That would be a real choice.

Instead, investors are being told they can't have their $100 back unless they reinvest in CPS, and even then that $100 might prove fleeting (the CPS could list at a discount). Anyone buying the PEPS after the record date of November 9 has no right to take part in the reinvestment and will be stuck with a long-term and probably illiquid holding.

Intelligent Investor speculates that the early record date was implemented to help the marketing offer for CPS (which brokers can legitimately claim are worth full face value, for now, because one can't "look through" to the future CPS price based on today's PEPS price).

It also shows all longer-term PEPS holders the consequences of not converting - which are partly the result of the gun at their heads.

Mr Market has already spoken. PEPS, which closed at $94 on the day before the offer announcement, traded as low as $85 and now trade at barely $90.

It seems the PEPS price is responding to concerns that the security will become illiquid and perhaps even delist.

If the market is behaving rationally, the CPS will struggle to attract much in the way of fresh money from willing investors. But, based on the post-bookbuild announcement, there's always a few hundred million dollars floating around.

In contrast, PEPS owners have little alternative but to switch to the CPS. Management is likely to be very successful in wrangling the great bulk of them to do so.

There's something deeply troubling about the whole process. PEPS holders are being corralled and manhandled into an offer they neither wanted nor have asked for. Without compensation, they have become the real underwriters of this new issue.

Investors have responded with barely a whimper.

It would help the Australian capital markets if regulators and exchanges worked together to ensure new securities arise only from the competitive crucible of willing buyers and sellers. Instead, in collaboration with the authorities, we get a "reinvestment offer" like this.

The message to Bank of Queensland is even clearer: just give PEPS holders their money back.

This article contains general investment advice only (under AFSL 282288). Nathan Bell is the research director at Intelligent Investor. See intelligentinvestor.com.au.

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