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Is Commbank’s new hybrid a real pearler?

Paul Rickard
Thursday, November 08, 2018

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Last Thursday, the Commonwealth Bank announced the launch of its latest ASX-listed hybrid security – CommBank PERLS XI Capital Notes. Set to pay a fixed margin of 3.7% over the 90-day bank bill rate and have an offer size in excess of $750m, the final terms of the issue will be announced tomorrow after a bookbuild today.

And while I am a fan of hybrid securities for investors who understand the product and the risks, like all markets, there can be times when it pays to just sit out and keep the powder dry. With the recent movement higher in bank ordinary share yields, plus the uncertainty over the ALP’s policy changes to dividend imputation, I think the hybrid market is at this point.

I don’t dislike the issue  – I just don’t think it is a real bargain. I will come back to this a little later, but firstly, details of the offer.

CommBank PERLS XI

CommBank PERLS XI Capital Notes will pay a quarterly, fully franked distribution. This is calculated at a fixed margin of 3.7% over the then 90-day bank bill rate, and then adjusted by the company tax rate (to take into account the benefit of the franking credits). The distribution is re-calculated each quarter.

With the 90-day bank bill rate currently at 1.95%, this implies a gross distribution rate of 5.65% pa for the first 3 months (1.95% plus 3.70%). The actual distribution in cash, which is fully franked, would then be 3.96% (5.65% x 0.70 = 3.96%).

Distributions are discretionary and subject to distribution payment conditions. If a distribution is not paid, it doesn’t accrue and won’t subsequently be paid. To protect holders from this discretion being mis-applied, Commonwealth Bank is then restricted from paying a dividend on its ordinary shares. 

Exchange into CBA shares or Early Repayment

PERLS XI are perpetual and have no term. However, CBA must (subject to a test) exchange the PERLS XI Capital Notes into CBA ordinary shares on 26 April 2026 (in about 7.5 years’ time). If exchange occurs, holders are issued $101.01 of CBA ordinary shares for every PERLS XI Note of $100 face value (which effectively means that they are issued CBA shares at a 1% discount to the then market price). The test for the exchange is the price of CBA ordinary shares at the time – provided they are higher than approximately $38.84, exchange occurs – otherwise, it is retested on the next and subsequent distribution date(s) until the test is met.

To qualify as regulatory capital for CBA, two further events cause mandatory exchange - a ‘capital trigger event’ and a ‘non-viability trigger event’. Under these tests, the Australian Prudential Regulatory Authority (APRA) can require CBA to immediately exchange PERLS XI into ordinary shares if CBA’s Common Equity Tier 1 Capital Ratio falls below 5.125% (the ratio was 10.0% on 30/9/18), or if it believes CBA needs an injection of capital to remain viable. In these distressed circumstances, exchange would most likely result in a holder receiving considerably less than $100 of CBA ordinary shares as there is a cap on the maximum number of shares that can be issued.

CBA also has an option to redeem the PERLS XI Notes early on 26 April 2024 (in approximately 5.5 years’ time) by paying holders $100 per PERLS XI Capital Note.  

Details of the issue are as follows:

CBA is also conducting a re-investment offer for holders of PERLS VI (ASX Code CBAPC). PERLS VI, which pay interest at a fixed margin of 3.8%, will be called (redeemed at the $100 face value) if investors do not elect to re-invest in PERLS XI. Payment will be made on 17 December.

How to invest

The offer is due to open tomorrow (Friday). Several brokers and financial planners are involved in the issue, including CommSec, Morgans, Morgan Stanley, Bell Potter, Macquarie and Ord Minnett. If you are investing via a broker or financial planner, many are receiving a placement fee of 0.75% and in some cases, may be willing to share some or all of this with potential investors.

CBA shareholders and holders of PERLS VI, VII, VIII, IX and X can also access PERLS XI Notes directly through a Securityholder offer at www.commsec.com.au (you don’t need to be a CommSec client).

My view

While this issue is reasonably priced compared to existing secondary market yields, I am not a huge fan for three reasons.

Firstly, it is priced on the lower side of the margins that CBA has previously paid for PERLS issues. Listed below is a table of previous issues, showing that the fixed margin has ranged from a high of 5.2% to a low of 2.8%.

History is not always the best guide and there are reasons why margins should be lower now including the very strong capital position of the major banks, lower issuance, and comparable margins in wholesale markets. This particular issue also has a relatively short term to the mandatory exchange and expected call date.

But this is an issue directed at retail investors and while 3.7% looks interesting, it is not riveting.

Compared to the yields available on bank ordinary shares, PERLS XI stacks up poorly. While they are very different securities, they do carry some of the same underlying risks. Whenever there has been a sell-off in bank shares (as there has been over the last couple of months), hybrid securities trading on the ASX have fallen in price and their effective trading yields have increased.  

Here is the comparison on a cash and gross (post franking) basis between CommBank’s PERLS XI and the closing yield on bank ordinary shares yesterday (1 year forecast from FN Arena).

* Closing price 7/11/18, forecasts from FN Arena for FY19 dividends. PERLS XI using current bank bill rate of 1.95%

Thirdly, hybrid securities will be impacted if the ALP’s policy to deny the re-funding of excess imputation credits in cash becomes law. My guess is that the big holders of hybrids are SMSFs, particularly those in pension phase. While there has been a lot of commentary about the potential impact of this change on bank shares and Telstra, the hybrid market hasn’t rated much of a mention. I doubt this is yet factored in.

Published: Thursday, November 08, 2018


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