New PERLS, new lustre

PORTFOLIO POINT: PERLS 5 offers good value compared to other CBA fixed income products and against major bank converting preference shares.

PERLS 5 are an A rated security, the fifth in the series of hybrid securities offered by the Commonwealth Bank. They are to be issued at the relatively high margin of 3.40% over the bank bill swap rate, and if the four standard conversion conditions are satisfied they will mandatorily convert to Commonwealth Bank ordinary shares on October 31, 2014.

The conditions are:

• The volume-weighted average price (VWAP) on the 25th business day before the possible conversion date (or if trading in bank ordinary shares did not occur on that date, the last business day prior to that date on which trading in bank ordinary shares occurred) is greater than 56% of the issue date VWAP.
• The VWAP during the period of 20 business days on which trading in bank ordinary shares took place immediately preceding, but not including, the possible conversion date is greater than 50.51% of the issue date VWAP.
• No delisting event applies in respect of the conversion date.
• The bank has not elected to resell all PERLS 5.

The most relevant conversion condition is the first one. If it is met then investors will either receive $202.02 (a 1% discount) worth of CBA shares (the default option), or $200 cash if the bank elects and receives approval from the Australian Prudential Regulation Authority. Essentially, the ordinary shares have to be approximately 56% of the current Commonwealth Bank share price on the issue date of PERLS 5. Based on today’s pricing, that would mean the Commonwealth Bank ordinary share price would have to be above $25.19 for this condition to be met.

It’s likely that the Commonwealth Bank ordinary share price will be above this figure and, in the unlikely event that it isn’t, these conditions are tested on each quarterly payment date thereafter. Generally the conversion conditions are standard clauses and the risk that the PERLS 5 won’t be converted at the first opportunity is low.

CBA strengths

The Commonwealth is one of a few banks worldwide that has maintained the high credit rating of AA from Standard & Poor’s. This allows it to raise and lend money at a lower cost to other institutions. CBA was recently ranked by Global Finance magazine as among the world’s 15 safest banks.

The bank showed strong sales and volume growth in key product lines for the year to June 30, led by its retail banking division. Commonwealth Bank is in a solid position with ample capital and liquidity to drive future lending growth and development throughout 2010.

CBA risks

The banking operations have an increasing exposure to bad debts, the biggest factor behind the decrease in profits. The Commonwealth Bank is highly exposed to the residential property market due to the high proportion of mortgages on its loan book.

Overall credit growth in Australia is expected to slow through 2010 and economic conditions are likely to remain challenging for the bank. Funding conditions for banks worldwide remain difficult and while the Commonwealth Bank with its AA rating from S&P is better placed than most, it remains a concern. Markets do however appear to be returning to normality.

PERLS 5 strengths

PERLS 5 will offer a high cash coupon relative to most bank hybrids. This means the total return to investors over the life of the security will be taken as income rather than a significant portion as a capital gain as is the case with the existing bank hybrids that are trading at a discount to face value.

Because PERLS 5 is structured as a mandatory converting preference share, this eliminates the uncertainty associated with conversion on the maturity date. As long as the conversion conditions are met – which is considered likely – investors will either receive $202.02 worth of Commonwealth Bank ordinary shares on October 31, 2014, or $200 cash.

PERLS 5 offers good relative value when compared with both other Commonwealth Bank fixed income products and other major bank converting preference shares.

PERLS 5 risks

As with all hybrid securities, there is the risk of coupon non-payment. If a payment is missed then it is non-cumulative, however there is the provision for it be made up via an optional payment (subject to APRA’s approval).

No Australian major bank has ever missed a coupon, to our knowledge, so we view the likelihood of coupon non-payment as low because this would enforce a dividend stopper on the bank’s ordinary shares, an unpalatable event for the company and its management. The bank would then either have to pay the optional payment or make four consecutive PERLS 5 distributions before it can resume payment of dividends on its ordinary shares.

PERLS 5 are a preference share, meaning they are technically perpetual securities. To meet the requirements of being a non-innovative tier-one capital instrument, CBA is unable to pay a step-up on the securities if they are not exchanged or redeemed at the first opportunity on October 31, 2014.

However, given the likelihood of the Commonwealth Bank’s share price exceeding the threshold amount (about $25.19) on that date, and the other conversion conditions being met, we view this risk as low. Also, in the event that conversion doesn’t occur on this date, the mandatory conditions will be tested on each quarterly payment date thereafter.

As a hybrid security, PERLS 5 will rank below all other bank depositors and creditors in the event of liquidation. However, investors in this security will rank above equity holders and investors in PERLS 3, who will be converted to ordinary shareholders in the event of a winding up. As an AA rated bank, the likelihood of insolvency is considered remote.

The following chart highlights the returns on the various products in the Commonwealth Bank capital structure. The PERLS 5 offers good relative value compared with most products. Importantly, it offers a higher spread than the similarly structured PERLS 4 hybrid. It also offers better value than traditional fixed income products, most notably the bank’s subordinated debt, which is currently yielding only about 2%. The 1.4% additional spread available on PERLS 5 more than compensates for the additional risk of being placed lower down the capital structure than subordinated debt investors.

The only fixed income product in the Commonwealth Bank capital structure offering a higher return is PERLS 3, which is currently trading on a spread of 4.58%. However, PERLS 3 is ranked lower down the capital structure than PERLS 5 and is a longer-dated security (seven years).

In summary, CBA is a well capitalised profitable bank and PERLS 5 offers investors a high cash coupon relative to other bank hybrids. Overall, PERLS 5 appears to be good value when compared to both other fixed income products within the Commonwealth Bank capital structure and also against major bank converting preference shares.

Jim Stening is managing director of FIIG Securities.