CBA PERLS VI: Of Wolf and sheep

In a recent memo, Oaktree Capital chairman Howard Marks made the point that ‘for one side of a transaction to turn out to be a major success, the other side has to have been a big mistake … Win-win transactions are much less common than win/lose transactions.’

Successful investing is all about profiting from the mistakes of others. Ideally, one stumbles across a high quality company that has a predictable and sound future but has been sold down by emotional, naïve or unthinking investors.

In the case of the latest bank hybrid offer, Australia’s biggest bank is in search of emotional, naïve and unthinking investors.

The bank is not a forced or emotional seller but a cold and calculating one. It’s raising capital in this form because it can strike a better deal here than elsewhere.

Opponent and referee

So Commonwealth Bank holds all the cards. It writes the rulebook (the prospectus) and has inserted clauses and conditions to shift risk from its books onto yours (see below).

Furthermore, the regulator, Australian Prudential Regulation Authority (APRA), demands even more conditions and levers to protect the bank’s depositors in any situation of financial distress, again at the hybrid investor’s expense.

It’s therefore extremely unlikely that the current crop of big bank hybrids will prove a ‘major success’ for investors. The best hope is for a fair deal; the worst is that yield-hungry buyers are accepting too much risk for too little return.

So far, the 2012 spate of hybrid offers has raised $10bn or so. That in itself is a warning sign, as companies only rush to market when investors are mispricing risk. There are many others.

PERLS VI has all the features of a preference share like ANZ CPS3 and Westpac CPS, both previously covered with a negative view.

There are similarities with previous generations of PERLS offerings (particularly IV and V) but this latest iteration is of an inferior quality (see Table 1 and Where does ASIC stand? pullout box for more detail).

Higher margin

One edge PERLS VI does have is in the payment of quarterly interest based on the three-month bank bill rate plus an expected margin of 3.8%-4.0%, higher than the 3.1% and 3.25% margins from the recent ANZ and Westpac equivalents. If underlying market rates were to hold steady in future, that’s between about 7.3%-7.5% on a nominal basis.

But both those securities now trade at a discount to face value (after adjusting for accrued interest), making the yield to maturity for today’s buyer similar to that of PERLS VI (see table 1).

Perhaps investors are finally wising up, demanding a greater margin for the risks embedded in these products.

Distributions are likely to be fully franked, although not as a free extra. The advertised margin incorporates a cash component and the franking credit value, as is the standard, though slightly sneaky, convention (see A frank discussion on dividends). If you can’t use franking credits—mainly non-resident investors—steer well clear.

Again, distributions are at the absolute discretion of CBA and APRA. Investors are also dependent on the bank having sufficient distributable profits to make the payment, and having the ability to do so without breaching capital requirements. Missed distributions are non-cumulative so those not paid will be lost to the sands of time.

That, though, might be the least of this product’s potential problems. After the Global Financial Crisis, banks have reduced their lending to corporate borrowers and doubled-down on home loans.

If Australian property is significantly overpriced there could be pain ahead. Add to that the banks’ dependence on foreign lenders, an increasingly edgy bunch, and Australia’s overall prosperity hitched to a Chinese wagon with rickety wheels, it’s not impossible to imagine Commonwealth Bank facing difficulties over the likely eight-year term of this security.

The fine print accounts for this scenario, but not in your favour. Whilst PERLS VI offer a limited debt-like upside when the going’s good, when it’s not investors face equity-like losses.

Key landmines

The ‘Capital Trigger Event’ clause and the ‘Non-Viability Event’ clause spell it out. The former means that if CBA’s tier 1 capital falls below 5.125% (it’s currently 7.5% as calculated under the Basel III framework, see page 37 of prospectus), or if the board or APRA even suspect it might fall below that level, PERLS VI will be immediately converted to ordinary equity.

The non-viability clause is the second bullet in the chamber. It allows APRA to force conversion if it believes Commonwealth Bank might become ‘non-viable’, even if it’s not breaching the tier 1 capital requirement.

Just imagine where Commonwealth’s share price might be trading in an environment where it’s deemed ‘non-viable’. Worse, a ‘Maximum Exchange Number’ would apply on any such emergency conversion (see page 22 of the prospectus).

Essentially, if the ordinary shares are trading at more than a 50% or 80% (depending on the situation) discount to their price at the time of this offer, then PERLS VI holders will immediately share in any further downside, probably at a time when those ordinary shares are in free fall.

There are other landmines in the fine print. Page 48 explains how, if either emergency clause is executed and the bank is unable to issue ordinary shares to PERLS holders within five business days then the ‘relevant Holders’ rights in relation to such PERLS VI … are immediately and irrevocably terminated’. That means a complete loss.

Page 49 highlights how ‘CBA may substitute a NOHC (non-operating holding company) as the debtor’, the corporate equivalent of reserving the right to transfer your debts to your unborn and soon-to-be-bankrupt child.

If directors and APRA both so wished, the bank could carve up its assets to preserve some value for ordinary holders or other stakeholders at the expense of PERLS VI holders. The Spanish government is currently considering such ‘good bank, bad bank’ carve ups in the name of saving their financial system, ensuring preference shareholders get wiped out in the process.

Equity by any other name

You get the picture. PERLS VI is exactly the sort of instrument a sophisticated and capital hungry bank might design to transfer risk to yield-obsessed but risk-ignorant investors, and appeasing the regulator, all without incurring the full expense of issuing new ordinary equity.

Two parties to the deal get what they want. APRA sees PERLS VI as a useful equity buffer against a future crisis. The bank gets fresh 'equity' without the expensive price tag. All of which comes at the expense of incoming securityholders, who will carry the remote but significant downside risk without the corresponding possibility of equity-like upside.

That begs a simple question: If PERLS VI means you wear the downside of a banking crisis but believe there won’t be one, why not simply buy ordinary bank shares and get the upside that goes with it?

A pothole-free future isn’t a certainty. The trouble with this and all the other hybrid offers is that as soon as one starts pricing in the possibility of calamity, the investment case collapses (see Income securities: Conservative investments or junk bonds).

Most investors in hybrids like PERLS VI believe they’re acting conservatively. They’ve, however, given too little thought to the possibility or consequence of calamity. This isn’t a ‘win-win’ offer but it may well be another lopsided ‘win-lose’. Give this offer a pass.