CommBank Retail Bonds get big tick

Recent income security offers, pitched to conservative investors, invite us to take on the risk of investing in shares with capped potential returns. In most cases, it isn’t worth it. The risk is not compensated by the meagre rewards on offer.

But, boy, have they been successful. Applications flooded in, highlighting a large and untapped demand for low-risk investments (especially those that aren’t low risk). Having trawled through older income security issues, we’ve found one that does fit the bill, assuming it falls by another 35 cents.

CommBank Retail Bonds might well be suitable for the low-risk, low-reward part of your portfolio, although they won’t be for everyone so please read what follows carefully.

CommBank Retail Bonds are honest-to-goodness debt. Interest payments aren’t deferrable and are not optional. If Commonwealth Bank misses just one interest payment, it’s an event of default. Let’s explain what that means.

Dividend stopper

For recent preference share issues, a ‘dividend stopper’—which halts dividends on the ordinary shares, too—is the main incentive the board has to make an otherwise optional payment. For the Retail Bonds, a missed payment means the board loses control of the entire bank. One incentive is a feather duster, the other a bazooka.

In any windup, the Retail Bonds rank behind account holders, term deposit holders and employee entitlements and are not government guaranteed. They also effectively rank behind the new-generation ‘covered bonds’, a wholesale instrument not generally available to retail investors, which have their own pool of assets as security.

They do rank alongside other unsubordinated wholesale bonds (the majority of bank bonds), ahead of all subordinated debts, preference shares like PERLS IV and V and ordinary shareholders. This is very high quality bank debt.

The second noteworthy point is the maturity date—24 December 2015. Many recent offers have maturity dates in the 2030s and for Origin Notes it’s 2071. This, however, is an investment you’ll collect on rather than your grandchildren. And unlike preference share offers, CommBank Retail Bonds mature as cash rather than bank shares.

They pay interest quarterly, equal to the 90-day Bank Bill Rate plus a margin of 1.05%. At the current 90-day bank bill rate of 4.2%, that adds up to annual interest payments of 5.25%.

Yield to maturity

But today’s buyer is able to buy the bonds at a 2% discount to their $100 face value, which means a small additional capital gain on maturity. Annualising that gain and adding it to the running yield, today’s buyer is looking at an overall yield to maturity equal to the 90-day Bank Bill Rate plus a margin of 1.9% (or 6.1% in nominal terms).

Assuming you pay 0.3% brokerage on your purchase (a typical rate from an online broker), the overall yield to maturity margin falls a little to 1.8% (6.1% in nominal terms) per annum.

The yield to maturity is floating, moving up and down with short-term interest rates, which may or may not suit your portfolio needs. This feature also makes comparisons with term deposits a little misleading, but not entirely useless.

A nominal return of 6.1% (what bondholders will receive if short term interest rates don’t move over the next four years) compares with the best rate we can currently find from a big bank-affiliated four-year term deposit of 5.6%, offered by CBA subsidiary Bankwest.

The additional return is adequate compensation for the slight extra credit risk involved. If interest rates go up, so will the return on the Retail Bonds. If interest rates go down, the fixed rate term deposits are likely to fare comparatively better.

Comparing the Retail Bonds with riskier bank securities, the yield to maturity is lower than the margins paid on recent subordinated note offerings from ANZ ( 2.75%) and Colonial ( 3.25%) and the significantly lower ranking preference share offers from Westpac and ANZ ( 3.25% and 3.1% respectively).

But CommBank Retail Bonds are safer than any of these recent big bank income and hybrid offerings. There is none of the nasty fine print we’ve seen elsewhere.

And as your investment will be redeemed for $100 cash in 2015 regardless of what the markets offers in the meantime, the risk of substantial capital loss is reduced to virtually nil if you’re able to hold on for nearly four years.

Price important

It’s in buying the bonds in the first place where liquidity might prove an issue. The price you pay is very important to the overall return for a short-term security like this, so we suggest setting any buy orders at $97.30 or less. This is not an offer worth chasing.

CommBank Retail Bonds aren’t for everyone. If you’re after equity-like returns, this is something you should avoid.

If, however, your aims are modest and your primary concern is with preserving what you’ve already got and making a modest, low-risk return from it, the opportunity is reasonable. It’s a clearly superior deal to the many new income security offers that have been stuffing your letterbox of late.

We’ve suggested a portfolio weighting of up to 7%, which is more a reflection of the safety of the investment than its attractiveness. If the returns and features suit your portfolio aims, consider taking a decent swing at this one once the price hits $97.30 or less. Until then, HOLD.