CommBank PERLS VII Capital Notes: Storm clouds brewing?

Commonwealth’s grossed-up for franking) is closer to 5% than 6%. This makes our ‘no hybrid’ argument (see margin to maturity for notes purchased today is a lot lower – about 2.6%. Importantly, they were also issued when the Commonwealth Bank share price was $56, so they’ve got a much lower Issue Date VWAP.

This means there’s less chance that the Conversion Conditions won’t get satisfied (meaning more chance you’ll get your money back on schedule) and less risk of either the capital or non-viability trigger events leaving you with ordinary shares of insufficient value to pay back your capital.

Of course, PERLS VI offer lower returns but if we were dabbling in hybrids (which we’re not) we’d be more focused on the margin of safety. We’ll pass once more on this offer, but if you’re considering it take a look at our reviews of the recent ANZ and Westpac offers and our general article on bank hybrids – Bank hybrids: What could possibly go wrong?

Let’s now take a look at some recent developments.

UK ban on sale of hybrids to retail investors

The UK’s Financial Conduct Authority (FCA) recently announced a temporary ban on the issue of hybrid instruments (called ‘contingent convertibles’, or CoCos, in the UK) to retail investors. The FCA, concerned they are inappropriate for the mass retail market, intends to introduce permanent regulations during the hiatus.

The FCA’s announcement has no direct relevance to Australia but it’s been followed by some media speculation that a similar ban might be introduced here. However, Australia doesn’t have an equivalent body to the FCA – an advocate for financial market and consumer protection – so any potential ban is a long way off. Despite that, it’s important to be aware of the issue, since if a ban were introduced, it would probably be during the lifetime of hybrids such as PERLS VII.

It’s hard to say what the implications might be. On the one hand, such a move would limit the supply of new hybrid issues (and constrained supply generally pushes prices up) but it could also see a lack of interest among brokers and bankers for pushing the asset class. In this case the latter is a very powerful factor.

Importantly, investors in bank hybrids are entitled to get their money back (fingers crossed) through conversion into ordinary shares. If future hybrid issues were constrained because of a ban on retail sales (and a lack of interest among institutions), the banks will have to issue more ordinary shares, a problem for ordinary shareholders rather than hybrid investors.

Note that this isn’t the case with a lot of the non-bank hybrids like Caltex Notes. Here, hybrid investors don’t have a mandatory conversion – they’re to be repaid from the proceeds of a future hybrid issue – so investors are effectively insuring the issuer against the risk that the hybrid market dries up.

Dividend imputation

In a recent Fairfax article we mentioned the risk of changes to the dividend imputation (franking) system and the potential impact on portfolios. Whilst we’re nowhere near that point yet, make no mistake: particular changes to the franking credits regime would be very, very bad for hybrids.

Each round of corporate buy-backs (as in Telstra’s latest offer) puts the refund of franking credits to pension-mode super funds on the radar. It’s a generous regime and we wouldn’t be at all surprised to see it wound back in coming years.

Should that occur, bank hybrid prices are likely to plummet, since their pricing relies on investors (many of them pension-mode SMSFs) valuing franking credits as being as good as cash. Without franking credits, PERLS VII becomes a note paying a 3.8% distribution and it’s value to many investors falls a long way below the $100 issue price.

So nothing much has changed with this latest hybrid issue from Commonwealth. Like the earlier offers, it’s a security offering a very low return for the risks involved. But the hybrid world itself might be changing for the worse. If you’re investing in this space, stay alert to the mounting risks.