Call date and final maturity date- beware of the price cliff

We think it is important to understand call / conversion dates relative to final maturity dates when analysing ASX listed hybrids.  The difference between these dates creates price cliffs that investors need to be aware of.  If secondary market credit spreads widen relative to the contracted coupon credit margin from an issuer, investors will stop pricing to the call / conversion date and start pricing to final maturity date.  This is because securities are less likely to be called / converted when the issuer is better off leaving the security on issue.  The issuer is not going to call the security and then re-issue another security at a higher yield.  The longer the final maturity date relative to the call / conversion date the larger the price drop will be as spreads widen. 

An example is the PCAPA, the CBA issued (non compliant with Basel 3) hybrid, which has a call / conversion date of April 2016 but is a perpetual otherwise.  The contractual coupon is BBSW 1.05% (fully franked (ff)), so it is quite low meaning it is more likely not to be called given rates look like being above that level.  It would be in CBA's interest to leave it out there as they cannot borrow more cheaply.  However there is a coupon stepup of 1% on April 2016 if the hybrid isn't called so that is a positive for an investor. 

From April 2016 the contracted coupon thus would become BBSW 2.05% (ff).  The PCAPA will be priced to April 2016 if spreads between April 2016 and perpetuity look like staying below BBSW 2.05% (ff).  In this case CBA will call or convert and reissue another security.  The PCAPA will be priced as a perpetual if spreads between April 2016 and perpetuity look like being above BSW 2.05% (ff).  When priced with a longer maturity date the capital volatility is higher for a given widening in spread.

Having said all that banks have traditionally always called /converted such securites.  History may not repeat of course.  The PCAPA are one of the lower risk hybrids on offer.  They have a face value of $200, and can't be written off or converted to equity at a loss.  If you are looking to park some money after selling some CBA shares perhaps then they are offering near 6% fully franked to April 2016 (less if priced as a perpetual), so that is a fair return.

If you are really bearish on markets just park your money in bank deposits or buy some CBAHA.  Lower return but much lower risk.