Suncorp CPS2: Hybrids change gear

A higher margin and a more generous conversion makes CPS2 a better offer than previous convertible hybrids. But is it good enough?

Key Points

  • CPS 2 offers a much higher margin than earlier convertible bank hybrids
  • Conversion mechanism has the potential to provide greater protection in a time of distress
  • An alternative to buying bank shares for yield

Let’s cut to the chase. We won’t be recommending dividend stopper’ on ASX-listed Suncorp ordinary shares (SUN);
 

  • Mandatorily convertible (at 1% discount) into SUN ordinary shares on 17 December 2019 (about seven years from issue date) with optional early exchange after 17 December 2017
     
  • Immediate conversion on a ‘Non-viability Trigger Event’ (APRA determining Suncorp is not viable)
     
  • Maximum Conversion Number (the cap on the number of ordinary shares each preference share can convert into) is initially based on 50% of the issue date share price but, with likely effect from 1 January 2013, this is expected to be reduced to 20% for conversion arising from a Non-viability Trigger Event.
     
  • Margin (over floating 90-day bank bill rate) of 4.65-4.85% (subject to bookbuild)
  • The last three points are worthy of special mention.

      Suncorp CPS2 CBA PERLS VI (CBAPC) Westpac CPS (WBCPC) ANZ CPS3 (ANZPC)
    Table 1: Comparison of bank hybrid securities
    Price ($) 100 100 99.40 98.00
    Official ranking  Preference share Perpetual note Preference share Preference share
    Risk characteristics Equity-like Equity-like Equity-like Equity-like
    Distribution rate 3m BBR 4.65-4.85% 3m BBR 3.8% 6m BBR 3.25% 6m BBR 3.1%
    Distribution type Cash franking credits Cash franking credits Cash franking credits Cash franking credits
    Compulsory distributions No No No No
    Cumulative No No No No
    Principal repayment SUN shares or cash CBA shares or cash Westpac shares ANZ shares
    Maturity date* 17-Dec-19 15-Dec-20 31-Mar-20 1-Sep-19
    Capital trigger Event No Tier 1 capital < 5.125% Tier 1 capital < 5.125% Tier 1 capital < 5.125%
    Non-viability trigger event Yes Yes No No
    YTM (on current price) 3m BBR 4.65-4.85% 3m BBR 3.8% 6m BBR 3.5% 6m BBR 3.7%
    * Date on which mandatory conversion to ordinary shares is expected to take place.

    Whilst CPS2 contains the Non-viability Trigger Event it doesn’t contain the ‘Capital Trigger Event’ found in CBA PERLS VI and the earlier convertible hybrids. APRA doesn’t say what might deem a group ‘non-viable’ but having one of these triggers to a forced conversion is better than two.

    The big problem with a forced conversion is that you lose your protection against the Maximum Conversion Number (MCN). The MCN caps the number of ordinary shares each preference share can convert into. If the share price has fallen below the percentage on which the MCN was originally calculated, it would causes losses.

    The scheduled conversion is delayed if this cap would prevent your $100 investment being repaid with ordinary shares having $101 value (allowing for the 1% discount). You simply hang on to your preference shares and keep receiving dividends until the share price recovers. But a forced conversion arising from a trigger event does away with that protection.

    In previous convertible hybrid issues the MCN has been calculated based on a ‘Relevant Fraction’ of 50% of the issue date ordinary share price. This same percentage is used for the scheduled conversion of CPS2. If the value of SUN on the CPS2 issue date was $9.00, then the MCN would be calculated as follows:

    MCN = 100/(9 x 0.50) = 22.2 ordinary shares

    The effect of using 50% as the Relevant Fraction is that investors suffer losses if a ‘trigger event’ has occurred and the share price has more than halved—likely in the circumstances. If the share price has fallen to $4 and conversion is capped at 22.2 shares, you’ll receive only $88 in shares per $100 investment.

    Using 20% as the Relevant Fraction for a forced conversion changes the cap to 55.5 ordinary shares and means the share price needs to fall by more than 80% for losses to be incurred. In the example above, you would still get $101 worth of ordinary shares. If the share price fell to, say, $1 you would get $55 worth of shares (versus $22 under the original formula). Losses are both less likely and lower—a more attractive proposition.

    Suncorp has indicated that they expect the Relevant Fraction to be 20% for conversion arising from a ‘Non-viability Trigger Event’, with effect from 1 January 2013 (when Australian financial institutions are expected to comply with Basel III). This is good news.

    The bad news is that the change to 20% depends on further notification from Suncorp (see p25 of the prospectus) rather than it being locked in now. It’s shameful but not a surprise that APRA has allowed Suncorp to issue a security targeting retail investors with uncertainty over its key terms. Would you buy a car where the manufacturer indicates it has four wheels but reserves the right to supply only three, after you’ve purchased it? Anyway, let’s assume the change to 20% proceeds in the manner anticipated.

    Finally, note the CPS2 margin of 4.65-4.85%. It’s a significant increase from the 3.1% offered on ANZ CPS3 during the early hybrid frenzy. With improved structural features, CPS2 pushes the risk/return equation into more sensible territory.

    A total grossed up return of just over 8% (at current interest rates and including franking credits) is not enough to scream ‘buy' but for those keen on buying high yield bank shares, it’s interesting food for thought.

    CPS2s versus ordinary shares

    In February 2012, Westpac ordinary shares were trading at $20.77 and had a forecast dividend yield in excess of 11%pa (grossed up). Back then, a Westpac convertible hybrid, offering less than 8%pa grossed up yield, no upside and carrying a good deal of the downside risks, didn’t hold much appeal. Much the same went for the other bank hybrid offers.

    Right now, Suncorp ordinary shares are trading at $9.23 with a forecast dividend yield just over 8% (grossed up). CPS2 offers a similar dividend yield but with less downside than the ordinary shares. So there’s been a significant change in the relative merits of each proposition.

    CPS2 investors won’t benefit from any share price appreciation but they are less exposed to sharemarket volatility and will suffer less in a distressed scenario (especially with the structural enhancements) than ordinary shareholders. If you have been buying SUN ordinary shares for yield, CPS2 offers an opportunity to take some profit without the yield sacrifice associated with switching to cash.

    Possible landmines

    If you’re considering this offer on that basis, please read our reviews of CBA Perls VI, ANZ CPS3 and Westpac CPS. Take particular note of the risk of hybrids being written off completely in the unlikely event that conversion to the listed ordinary shares is unable to occur.

    The key difference between them (apart from the structural features and extra margin noted above) and this offer is that Suncorp is not a big four bank and is more heavily concentrated in Queensland. With a lower credit rating, it would be regarded as a more risky proposition.

    However, we think the risk associated with bank hybrids is more systemic than specific. Losses are more likely a result of macro factors like a property price crash than a standalone event making a single institution ‘non-viable’. Suncorp isn’t necessarily more exposed than the big four but it is paying a return as if it were.

    Remember also that the declaration by APRA that a regulated institution is non-viable could, of itself, have systemic ramifications. If Suncorp were to experience, for instance, large insurance losses, a fresh issue of ordinary share capital may be more palatable to APRA than relying on the loss-absorbing features of CPS2, which may trigger concerns about the strength of the banking system.

    Finally, don’t forget the risk associated with the 1% share price discount on conversion. This is insufficient to cover normal share price volatility and investors run a significant risk of a small capital loss on conversion.

    Unfortunately, the share price discount isn’t amended to reflect the greater volatility of Suncorp shares compared with those of the big four. That means CPS2 investors are taking even more risk that they will end up with a small loss (or gain) on conversion.

    Interesting option

    Still, Suncorp CPS2 offers a higher margin than other bank convertibles with greater potential to mitigate loss if Suncorp faces times of distress. It’s an interesting option for those buying bank shares for yield. We're not ready to recommend a listed hybrid offer yet, but Suncorp CPSs is a definite improvement.

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