CBA PERLS VII CAPITAL NOTES - Think twice before buying

The more you know about an investment’s potential performance under a worst case scenario the more prepared you are both emotionally and financially to make good investment decisions.  Preparedness includes correctly pricing for the long term as well as being ready to transact, by either buying more or selling, under adversity.  

An assessment of the PERLS VII, an Alternative Tier 1 Basel 3 compliant Bank Hybrid currently in vogue, starts with an understanding that these securities are equity-like.  They include more adverse terms for investors than previous hybrids because APRA (the bank regulator) wants these securities to contribute to the solution should banks get into trouble.  All the major banks have issued these Basel 3 compliant hybrids and we use the CBA issue as an example representative of the sector.

The worst case scenario for investors is that the PERLS VII can be written off at any time before maturity, after a Capital Trigger Event or Non-Viability Trigger Event, after an exchange to equity is not able to be facilitated within five business days and while the bank is a going concern.  That means the bank owes you nothing. Non-Viability is the more likely trigger in a financial crisis as an inability to raise funding to stay solvent makes a bank non-viable and can happen before losses actually appear in a bank’s financial statements.  This clause means the investor has sold an option to the bank issuer or, indirectly, a regulator to use at their discretion to save the bank.  This is a very generous option to the issuer and investors need to make sure they have been paid for it, and be aware of the market volatility it will encourage during any future adverse economic circumstances.  Pricing such options is a subjective assessment and includes considering the probability of the option being exercised.  Would such options have been exercised in 1981, 1991 or 2008/09?  We don’t believe the write off option would have been utilised by CBA or the other major banks in the past (had these type of securities existed), but possibly would have been by smaller State banks that were taken over by the larger banks in 1991.  The option, even if not used, will impact price volatility under adversity.   

Another poor scenario for investors, and the one that potentially plays out before the worst case scenario unfolds, is that the capital notes are converted into equity at an equity price that has fallen by more than 50% from the equity price at time of issue of the PERLS VII.  In this case you would receive less than 100% in value with the deficiency dependent on how low the equity price has fallen past the 50% level.  Would the conversion option have been exercised historically?  We think this option, had it existed, would have been triggered by a Non-Viability Event and used in 2008/09 prior to the provision of government guarantees on bank senior debt.  If banks needed government guarantees they must have been non-viable, under the terms of issue, and APRA’s intent would be for banks to force conversion before government guarantees were organised – that’s why the new terms came in, regulators were unhappy organising the guarantees in 2008/09 with hybrid investors getting the benefit.  All value would have been redeemed if the equity price at the time of conversion was at least 50% of the equity price at the time of issue of the hybrid, otherwise not. 

We think the Alternative Tier 1 Basel 3 compliant Bank Hybrids should be trading at a margin 1% higher than currently on offer for the potential risks created by the options sold by investors, such a yield being closer to an equity-like yield.   PERLS VII were issued at a franked margin of 2.80% (before adding BBSW).  We think the margin should have been 3.80%. 

A good risk management tool, given the equity-like characteristics of these securities, is to include them in a diversified portfolio of investments.

If you understand the poorer scenarios and their likelihood you will be ready to make rational decisions during both good and bad times.