Should you buy Bendigo and Adelaide Bank CPS 3?

Key Points

Soon after announcing its offer of Convertible Preferences Shares 3 (CPS 3), Bendigo and Adelaide Bank raised the size from $200m to $225m. The strong demand isn’t surprising, as the 4% margin over the bank bill rate paid by CPS 3 looks attractive given low interest rates.

No doubt demand for CPS 3 increased further after the Reserve Bank subsequently cut the official cash rate to 2%. At current bank bill rates, the 4% margin results in a 4.4% fully franked yield for CPS 3 (assuming a 30% corporate tax rate) and a grossed-up yield of 6.2%.

Even before considering taxes, this compares favourably to the 3.5% rates currently being paid on 5-year term deposits and the current 2.3% yield on 5-year government bonds. Yet one of the fundamental principles of investing is to ensure your potential reward compensates you for the risks taken, and we don’t think this is the case here.

More equity than debt

Unlike term deposits, CPS 3 is not guaranteed by the government. And unlike bond interest, dividend distributions from CPS 3 are at the discretion of the company. This means it is more like ordinary shares than debt, with similar risks to ordinary shares but lower potential returns.

Due to its dividends varying with future interest rates the price of CPS 3 is unlikely to deviate much from its $100 face value, so investors are likely to earn, at most, a small capital gain. It is also a perpetual instrument, so investors will have to sell on market to get their money back unless BEN exercises its options to redeem it on June 15, 2021, or if certain other events occur. 

Should BEN ever get into financial difficulty, however, the company will probably exercise its option to stop paying dividends, even though this would mean dividends on its ordinary shares also cease. In that event, the price of CPS 3 would probably plummet. Ordinary shareholders would also face substantial losses but, unlike holders of CPS 3, they can benefit from share price rises.

There is also a chance CPS 3 holders will have their investment converted into ordinary shares, either at the option of the company or forcibly if certain events occur. In a worst case scenario, CPS 3 could be written off entirely. 

Not compensated for risk

CPS 3 is higher in the capital structure than BEN’s ordinary shares and so, at least in theory, CPS 3 holders have less chance of making a permanent loss than ordinary shareholders. Yet despite its legal form CPS 3 is designed to act like ordinary shares ? but only on the downside. That is, it carries a large slug of the risk on the downside while the upside is capped.

If you are taking equity-like risks, then you deserve the chance to make equity-like returns. At current prices shares in Bendigo and Adelaide Bank pay a fully-franked yield of around 5.5% for a grossed-up yield of 7.8%. That’s 26% higher than the 6.2% yield on CPS 3 and, as noted above, ordinary shareholders also have the chance of making decent capital gains.

Of course, this is balanced by a greater possibility of loss, but we’d say the balance of risk and reward is that much more attractive. You could even design your own ‘hybrid’ by splitting your money between shares and cash, and we’d say this approach would also deliver a better balance of risk and reward than the CPS 3.

Bendigo and Adelaide’s CPS 3 is yet one more example of a bank taking advantage of investors’ desire for yield and franked dividends to raise cheap capital, ensuring it enjoys most of the benefits while transferring most of the risks to investors. We recommend you steer clear, particularly if you already have a large exposure to the Australian banking sector.