Suncorp's big deal

Suncorp-Metway, Australia’s sixth-biggest bank and second-largest insurer, has just announced the issue of $325–400 million of five-year convertible preference shares to repay existing debt, finance new loans and, as the company has said, for other corporate purposes.

Suncorp-Metway, which was formed in 1996 by a merger of Suncorp, Metway Bank and the Queensland Industry Development Corporation (QIDC), recently merged with Promina and owns brands that include GIO, AAMI, Australian Pensioners Insurance Agency (APIA) and Vero. It was the first Queensland-based company to post a $1 billion profit and is headed by former Commonwealth Bank executive John Mulcahy.

Its shares closed yesterday at $13.28, up from a 52-week low of $11.08 on March 7, but significantly down from highs above $21 in October last year.

The issue looks to be an attractive proposition for conservative investors based on the initial pricing guidance given to the market. Suncorp intends to pay floating rate, quarterly gross dividends at between 3.20% and 3.60% over the 90-day bank bill rate. The actual margin will be set next week and fixed for the life of the deal, so it will be known before the securities are actually issued. At the indicated range and current 90-day bank bill rate (about 7.8%), this equates to between 11.00% and 11.40% (including franking).

To understand the offer, we need to look back at the issue/reset margins for similarly rated securities before the global credit meltdown. For example, in June 2006 St George issued a hybrid at a margin of 1.10%; in December 2006 it issued at 1.20%; and by December 2007 the required margin had moved to 1.60%.

So what’s the catch? Well I don’t really see one; hybrid funding works for banks and insurers in particular, because they can use surplus franking credits and their strong credit rating to generate a very solid and low-risk investment for investors. Importantly, though, it is still cost-effective for the issuer despite the high gross return to investors because the company only has to pay the cash component of the dividend, with the balance of the return made up by the franking credit component. If we assume the final margin is actually set in the middle of the range at, say, 3.40%, this equates to a gross dividend of 11.20% but, as noted above, the actual cash cost to Suncorp would only be 7.84% (70% of 11.20%). So as you can see it’s a win for both the issuer and the investor.

If you are allocated securities (the best way to do that is talk to one of the named brokers who will have a firm allocation of stock) you will simply receive the quarterly dividend with the franking component claimed from the tax office at year end. Importantly, this cash dividend amount will be reset every 90 days in line with changes to interest rates. In the current environment, where there is probably still more pressure on rates moving up than down, this means that your income level will increase should interest rates continue to rise.

This is clearly a good avenue for investors seeking regular income from a relatively low risk investment. All investments of course involve some risk, but compared to the mortgage schemes and the like that investors had to chase to get this kind of return in the past, this would appear to be a much better proposition given Suncorp’s strong credit rating and the fact the security has been rated “A–” by Standard & Poor’s.

Interested investors should always read the prospectus for all the terms, but the most likely outcome is that in five years’ time the securities will either convert into $101.01 worth of Suncorp shares (based on a 1% discount at the time) or they are redeemed for $100 cash; again there are a couple of mechanisms by which this can happen so read the detail or have a licensed adviser explain it to you. And as always consider your own circumstances and objectives.

Steven Wright is director of fixed interest at ABN-Amro Morgans. The broker has been appointed the sole senior co-manager to the issue of Suncorp converting preference shares.