Why CBA shares outrun PERLS

PORTFOLIO POINT: Investors considering CBA’s PERLS VI hybrid note offer should do their homework, including a comparison with the returns from the bank’s ordinary shares.

Commonwealth Bank of Australia announced last Wednesday that the book-build for its PERLS VI hybrid note offer had achieved a volume of $1.5 billion and the credit spread on the fully franked coupon was set at 380bps over the 90-day bank bill rate.

CBA had not previously indicated a target credit spread, but market knowledge had put the range at 380bps to 400bps.

The volume raised in the book-build is broker firm and, as a result, CBA cancelled the general offer of the hybrid notes. Nevertheless, CBA ultimately expects to raise an even greater amount, as the security holder and customer offers remain open, along with the opportunity for existing PERLS IV holders to rollover into PERLS VI.

At $1.5 billion the PERLS VI issue becomes the largest issue of hybrid notes this year, although Westpac ultimately sold $1.68 billion of higher-ranking subordinated notes in August. The PERLS VI hybrids also take the total volume of fixed-income type investments aimed at retail investors so far this year, to $10.4 billion.

So how do the PERLS VI hybrid notes stack-up as an investment opportunity?

Unlike other recent Tier 1 capital issues seen from the ANZ, Westpac, CBA subsidiary Colonial Finance, and IAG, this will be the first Basel III compliant issue. As such, the key differences relate to the loss absorption capacity of the PERLS VI.

The prior issues have included a mandatory equity conversion trigger upon the issuer becoming non-viable. Non-viability was defined as the issuer’s Tier 1 capital ratio falling to 5.125%. The PERLS VI have two triggers with similar effect.

The first trigger is referred to as a Capital Trigger. This can be exercised at CBA’s discretion, or as directed by APRA, when CBA’s Level 1 or Level 2 Common Equity Tier 1 capital falls to 5.125%.

The Level 2 ratio stood at 7.82% under the Basel II measurement, and at 7.5% under the Basel III measurement, at the end of June.

Level 1 and Level 2 refer to the CBA’s group structure. Basically, Level 1 consists of the bank itself and other APRA approved banking subsidiaries. Level 2 consists of the Level 1 entities plus other core subsidiaries approved by APRA. Level 2 capital ratios will typically be lower than Level 1.

The second trigger is Non-Viability and comes into effect when APRA believes CBA is about to become non-viable, and ahead of any injection of public funds to restore the bank’s viability.

Upon a Capital or Non-Viability Trigger Event occurring, the PERLS VI will be converted into sufficient ordinary shares to restore the minimum Common Equity Tier 1 ratio. Conversion will allow for as much as an 80% fall in the CBA share price from the time of the PERLS VI being issued.

This is more generous than the 50% allowed in the earlier Tier 1 capital issues. However, should the CBA be unable to issue new shares, the PERLS VI will simply be cancelled with no compensation payable. 

The PERLS VI also differ in relation to the call and mandatory conversion provisions to the extent that the call date will occur in December 2018 but mandatory conversion will not take place until two years later, at the earliest. Calling the PERLS VI notes will be subject to APRA approval (but CBA has a good track record) and mandatory conversion will be subject to the usual conversion tests. Otherwise the notes are perpetual.

In return for accepting many of the risks associated with holding shares and none of the upside, investors will be rewarded with a deferrable, non-cumulative coupon that will yield the pre-tax equivalent of 7.4% per annum, based on the 90-day bank bill rate last Wednesday. Or to be precise, investors will receive a cash coupon yield of 5.18% per annum plus franking credits.

Potential investors may like to consider that CBA shares currently offer a yield of 6.1% per annum plus franking credits, along with all the upside that comes with hold equity. They may also like to ponder the significance of ASIC’s warning to retail investors appearing on page 2 of the prospectus, in the place where the chairman’s letter to investors is often found.

Philip Bayley is a former director of Standard & Poor’s and now works as an independent consultant to debt capital market participants. He also writes on matters concerning debt capital markets and banking for various publications and is associated with Australia Ratings.