Time to review CBA Perls

In striving for success with its '€˜covered bonds' CommBank has not done any favours for the Perls hybrids, especially Perls III.

PORTFOLIO POINT: Our modelling suggests the price of Perls III has further to fall. Investors should think about selling.

Deciding when to sell your fixed income securities isn’t always clear-cut. Part of the beauty of the asset class is that you can buy the securities, enjoy the known income stream and wait for repayment of capital at the call date or maturity. Some hybrid securities are perpetual so to recoup your investment you must make that decision to sell.

One obvious reason to sell is a decline in credit quality of the issuer. If the market perceives a higher risk of wind-up then it will demand a greater credit spread to compensate investors.

Many investors are happy to hold fixed income securities until maturity, so there’s never a question of actually making the decision to sell. However, the fixed income market, much like the sharemarket, is moving constantly and dedicated fixed income professionals are always looking for anomalies that make the buy, sell or switch options worthwhile. Often part of our assessment is considering good relative value. How does the risk/reward compare to other securities in the capital structure or how does it compare to securities that have a similar credit assessment?

One such opportunity arose recently when CommBank issued its first domestic AAA-rated covered bond paying a credit margin 175 basis points over the bank bill swap rate (BBSW). Covered bonds are the lowest-risk securities in a banks’ capital structure (see the second graphic, below). The high spread which the covered bonds were issued effectively meant investors in all other securities lower in the capital structure needed to be paid a greater spread to compensate for the perceived higher risk (remember when spreads widen, the price of the securities needs to fall). In fact, CommBank’s underlying credit quality had not changed dramatically. The higher spread demanded by the market was a factor of:

  • Increased global cost of funds for banks. Banks need to refinance significant borrowings and greater issuance inevitably leads to having to pay higher margins as the market reaches saturation.
  • Credit rating agencies highlighting wholesale market reliance for Australia’s “big four” banks.
  • CommBank needing to make its first covered bond issue (which, coincidentally, was a large issue of $3.5 billion) a success and some uncertainty as to what spread the market would accept.

Prices of bonds in the wholesale market adjusted quickly, however ASX-listed retail bank hybrids have lagged. Efficient market theory suggests that it is only a matter of time until these securities are also re-priced downwards.

The graph below highlights the spread differential that the market has historically required for holding the various debt securities for major banks and includes the CBA Perls III and its covered bond. It is a graphic depiction of the additional compensation needed for the additional risk associated with being lower in the capital structure.

The graph shows that CommBank’s covered bond spread has contracted since first issue by about 35 basis points (bps) to 140bps and over the same period the CBA Perls III (PCAPA) has widened 18bps to just over 360bps, somewhat increasing the spread between the two.

However, PCAPA should widen further. It is higher risk than Perls IV and Perls V in that it ranks the same as ordinary shares in liquidation. So, its return should be reflective of equity returns rather than lower-risk hybrid returns. Assuming the security should at least pay the equivalent of Tier 1 hybrids, the spread would have to widen to 400bps, meaning the price of the security should fall by $2.35 (based on Friday’s prices). I think it’s not unreasonable, given the higher risk involved with this security, that its spread should be 50bps higher than Tier 1s given its equity status. Which means, according to our modelling the price has further to fall, in the vicinity of $3.21. It’s clear in this instance that investors holding PCAPA, should sell prior to the price declining further.

A couple of other interesting items:

  • We expect further covered bond issuance in Australia, as the banks make use of this low-cost-of-funding tool. By their nature covered bonds are very low risk and sit very high in the capital structure. In effect, they subordinate senior debt and other securities in the capital structure and the banks should have to pay higher spreads on these securities to compensate (much of which has already been built in).
  • If you are a fixed income investor you need to build a relationship with a broker. A good broker should be notifying you of opportunities to buy, sell and switch in the market. Holding ASX-listed bank hybrids might seem innocuous enough (as none of us expect CommBank will go broke) but it’s that assessment of relative value and the understanding of whether you are being paid enough for the risk involved. Retail investors without specific fixed income research would find it very difficult to make that assessment.

Elizabeth Moran is director of education and fixed income research at FIIG Securities.