Queuing for the next CBA PERLS issue?

Commonwealth Bank’s PERLS V (ASX code: CBAPA) securities are likely to be redeemed in October by the bank for the par value. Five years after the issue of the securities in 2009, investors will receive their $200 back as shares or cash, or as is being anticipated holders of PERLS V may be able to roll their investment into a new issue by CBA.

If the predicted scenario plays out then a new CBA issue of PERLS is likely to be well received by current holders of PERLS V, who will be first in line to receive a holding (they must be registered as holders on the “Reinvestment Offer Record Date”). After the first around of offers, security holders of other CBA securities can apply and this may be followed by a public offer.  If it is like other recent issues of hybrids, the issue will most likely be oversubscribed.

Recently the price of PERLS V has continued to trade above $200, despite already paying the last distribution before redemption later this year. Weighted average volume traded in PERLS V in the last month is above the volume traded over the last year.

Under normal circumstances, it would have been expected that PERLS V would have traded closer to par value i.e. $200 at this point in time.

Investors buying now have already booked a loss – as it was only possible to receive $200 par value back in October (either as CBA shares or cash). As can be seen in Figure 1 the price of PERLS V has traded in a range of about $201.5 to $205 over the last year and the current price is in the middle of that range, with just over two months left to maturity (October 2014).

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David Murray recently highlighted in his Financial System Inquiry that banks need to increase their Tier 1 capital from current APRA acceptable levels by $23 billion, which equates to an increase of about 2-3% up to levels of around 10%.  This could indicate that there will be bigger and more frequent hybrid issues in the coming months. In the latest end of financial year results CBA’s Tier 1 capital was 9.3%, up 1.1%, which is above the current APRA standard of 7% expected by 2016. However, there is some dispute by the banks with respect to Murray’s inquiry as to the calculation of capital levels.

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What happens next?

Buyers of PERLS V above the par value of $200 are hoping for a couple of possible outcomes:

• A new CBA PERLS issue priced around the 300 – 320 basis points (bps) margin, so it would be more attractive based on the yield to maturity (YTM) at issue of at least 6.1% relative to PERLS VI current YTM of 5.35% (YTM is the expected return based on the current price, assuming all distributions are made through to conversion, and the face value of the security is realised at maturity);
• First right to participate in the next issue (as a registered holder), which will most likely be hotly contested; and
• A jump in the price on listing, leading to a capital gain up front.

We tried to confirm with the Commonwealth Bank the likelihood of another issue of PERLS taking place, but as to be expected the answer was “no comment”. Nonetheless, it would be unprecedented for a bank with a maturing hybrid not to follow up with another hybrid issue – especially with more pressure on banks regarding Common Equity Tier 1 levels (Figure 2).

But whether it makes sense to buy the next hybrid if it eventuates depends on whether you intend to hold to maturity. YTM will be a decisive factor as to how the new issue stacks up against CBA ordinary shares and other similar securities on offer.

If your intentions are not to hold to maturity, then the premium paid for PERLS V in order to become a registered holder will impact the issue coupon (issue coupon is the security’s issue margin plus the BBSW, plus franking credits divided by the price of the security) of the new PERLS. The premium paid will be an one-off loss and will effectively lower the issue coupon of the anticipated “PERLS VII”.

PERLS VI paid a margin of 380 bps above the BBSW rate, which was above the 340 bps margin for PERLS V – but the current market for other bank hybrids is seeing margins between 305-320 bps, so the next issue will most likely be paying a smaller margin than previous issues.

Small investors are buyers, not institutions

The majority of investors in hybrid-style issues are small investors (less than $50,000 per holding) or self-managed superannuation funds (SMSFs). Small investors and SMSFs are hungry for yield and the bank issues of hybrids are meeting their appetite.

Institutional investors are not interested and have not been the target audience – most likely due to the pricing (the margin over the BBSW rate) being insufficient to compensate for risk. PERLS rank as preference shares, just above ordinary shares in the capital structure, and the issuer has minimal obligations to the investor, with distributions being discretionary and noncumulative, plus the added risks of the potential for securities to be converted to equity or in the worst case scenario, if considered non-viable (by APRA), written off.

The next PERLS issue

If “PERL VII” eventuates on the expiry of PERLS V current buyers of PERLS V will be taking a loss upfront and resulting reinvestment into the next issue, which will result in a lower YTM than the issue YTM. 

Buyers of the expected next issue of PERLS have to make the decision whether they are willing to buy PERLS V now, so they know in advance the premium being paid for the next issue – although there is the opportunity cost of tying up funds until when the first distribution is likely to be paid for the new security, and also the unknown yield on issue.

But waiting for the listing of the new security before buying increases uncertainty as to how the price will move once it starts trading. If the same pattern emerges as we have seen with other listings of hybrids, the price is likely to jump above the par value quickly, especially considering how other similar securities such as ANZPE and WBCPE are trading in the market.

Alternatively, if you hold your PERLS V to maturity this is what happens: For every PERL V security you own you will receive the par value of the security in the form of cash or CBA shares i.e. $200. Plus under the original terms of this note, if you receive CBA shares you will also receive a ‘discount’ of 1% or $2 indicating an effective value of $202 per security.

The current yield of CBA’s ordinary shares grossed up is about 6.6%. Depending on the margin of the next issue of CBA’s hybrids, the PERLS may offer comparable value with respect to yield.

A 310 bps margin above the BBSW rate (I am taking an educated guess as to the size of the margin) would result in a higher YTM at issue for the new issue of PERLS.

The volatility of hybrids is lower than ordinary shares – meaning less downside risk but also less upside rewards. But with the rally in CBA’s share price, (see Figure 3 for total performance including franked dividends) downward price pressure from here may be expected (CBA’s price pressure point).

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Comparable hybrid issues

Other listed hybrid issues that are comparable to the anticipated next CBA PERL issue are WBCPE and ANZPE.  As can be seen in Figure 4 both have been strong performers recently.  The support for their share price indicates the likely demand that a new issue of PERLS would receive on listing.

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Remember the risks

During extreme market events some hybrids may behave more equity-like. During the global financial crisis (GFC), PERLS III fell 37% (Figure 5) from its issue price of $200, and has slowly recovered but is yet to reach prices seen pre-GFC. The slow recovery in the price has been due to the repricing of spreads and more attractive options available.

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The risks of hybrids are closer to shares than to bonds, and include the following:

•  Risk of a capital loss if the issuer becomes non-viable;
•  Risk of not receiving distributions; and
• Call risk, which is the chance that the term of the security becomes perpetual (no maturity date).