Why CBA's PERLS VII isn't a pearler

Hybrid securities continue to be well supported in the market as investors buy them for the relatively higher yield compared to other interest bearing securities.  The announcement that we expected about Commonwealth Bank’s next issue of hybrids, PERLS VII, is likely to facilitate this ongoing strong demand for yield. 

PERLS VII may be seen as an attractive yield play, compared to the negative return after inflation from term deposits and also based on the yield to maturity (YTM) on issue compared to other hybrids currently trading.  (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).

But I think the new PERLS issue is less attractive based on its relative value with the CBA’s gross dividend yield of 7.7%. 

And this hybrid issue has a couple of caveats attached for potential investors, including the likely unprecedented size of the issue (could be more than $2.5 billion) and the higher risks associated with hybrids that are issued to boost the bank’s Tier 1 capital during times of stress.  

Despite my concerns about this issue I expect any security that offers a yield above the current term deposit rates will be bought, especially in the current low yield environment.  Demand will also be supported by the recent warning from the Reserve Bank about interest rates remaining where they are for a while, and with fewer alternative options to make a positive return.

Below I discuss what this issue may mean going forward for investors in hybrid issues, and offer some comparative valuations of the current bank hybrids with the pending issue by CBA.

The next issue as we expected

Earlier this month I wrote about the next CBA hybrid issue (Queuing up for the next CBA PERLS issue).  It was not a done deal then, but certainly was likely to happen for a couple of reasons.

The first reason is the expiry of PERLS V this year, and the banks generally fund the redemption of the face value with another issue.

Secondly, the recent Financial Services Inquiry highlighted concerns about the big four banks’ Common Equity Tier 1 capital being less than it should be.  Although CBA announced recently an increase in its Common Equity Tier 1 capital to 9.3%, which is well above the APRA approved level required by 2016, the bank needs to have some additional Tier 1 capital available as part of a contingency plan.

My question is, why is the size of the issue so big ($2 billion that could go to above $2.5 billion depending on demand)?  Especially if CBA’s current capital levels are strong. 

The justification for the size of the issue could be that CBA is just being prudent.  Or another reason could be to strike while it can, and take advantage of the seemingly insatiable demand by retail investors for yield products such as hybrid securities.

But pricing is not as good

I thought the next issue would be priced on an initial yield with a margin (above the Bank Bill Swap Rate or BBSW) that was more than 300 basis points (bps) – equating to above 5.65%.  But the range where the margin will be set is lower at 280 – 300 bps, a yield of about 5.45% to 5.65%, with the lower margin more likely due to demand for the issue.

The lower pricing is possible due to the following:

• Demand of investors – Even at the lower end of the range, the initial yield of 5.45% for those that take up the issue (paying the face value of $100 per security) may still seem a reasonable yield, especially relative to term deposits; 
• Low interest rates – There is no end in sight for low interest rates, encouraging investors’ interest; and
• CBA’s strong financial result for fiscal year 2014, which gives the bank more leverage with respect to investor demand.

Positives and Negatives

Positives to support investment in “PERLS VII”:

1. PERLS will provide a source of regular income that, although it should not replace bond investments, is an alternative income investment with higher risk;
2. Issue face value of $100, which offers more flexibility compared to PERLS V’s face value of $200;
3.  As the hybrids are floating rate securities their yield will adjust with cash rates;
4. Payments will be discretionary, as is the case with other hybrids, but a dividend stopper means that payment will be ahead of CBA shareholders;
5. Liquidity should be good based on the other hybrids listed on the ASX, although during significant downturns liquidity can be lower; and
6. Volatility of hybrids during protracted downturns in the market is generally half as volatile as ordinary shares in such circumstances.

Some negatives to consider:

1. Basel III compliant and will contain both non-viability and capital trigger conditions, which means that in the event of  financial hardship suffered by the bank it can force conversion to shares – which many result in investors receiving shares worth a lower value than the face value of the PERLS VII;
2. The lower issue margin of 280 bps over the BBSW is 100 bps less than the margin for the last issue, PERLS VI, which was at 380 bps over the BBSW;
3. Retail investors are the target audience – as the terms do not meet the risk/return expectations of wholesale investors;
4. The risk of the securities is close to the risk of ordinary shares – but holders of the PERLS do not have any voting rights; 
5. Potential investors who are not current holders of PERLS V or other CBA securities may have to buy the securities when they are listed on the ASX, which may mean paying a premium to the face value;

7. Unparalleled size (may be at least $2.5 billion in total) of the issue may mean the market is oversupplied, alongside likely further issues by other banks; and
8. The long term to maturity (first call when the notes may be redeemed is at eight years) exposes the investor to interest rate risk (rising interest rates) and the risk of loss if a contingency event happens forcing conversion into shares.

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How do “PERLs VII” compare?

The yields of most other currently trading hybrids have been compressed due to strong price performance. 

So, PERLS VII will offer an attractive return to current holders of PERLS V that participate in the initial offer (must be holders of PERLS V on the “Reinvestment Offer Record Date”, August 22, 2014).  Subject to where the margin is struck, the minimum issue coupon of PERLS VII will be 5.45% and minimum yield to maturity around 5.92%. 

The current yield (coupon divided by price) is higher for other securities but if the PERLS are held to maturity the YTM is higher, so it may be better value relative to other hybrid securities if held for at least eight years. (see table 1).

Recommendation

Based on the lower margin over BBSW than expected and the long term to maturity I would not buy PERLS VII. 

The maturity date or the first call date is in eight years when the face value of $100 may be returned, but there are two scenarios that could play out preventing redemption into cash or shares:

1. Interest rates may rise to much higher levels than the margin of 280 bps the securities may be issued at – so in eight years CBA decides not to redeem the PERLS as this is a relatively inexpensive source of funding; or
2. The high price of CBA ordinary shares now means that there is a risk that the shares could fall close to the 50% of the price set at issue used as the benchmark in 10 years, which prevents conversion into shares and then the PERLS become perpetual.

Other factors to consider are the larger dividend payment announced by CBA following its annual result, which boosts gross dividend yield to 7.7%. I do not think the yield offered by PERLS VII is sufficient for the extra risks of the hybrids compared to holding the ordinary share.