Investors searching for a little bit of yield with relatively low capital risk will be tempted to consider two new capital note issues. The first, from Macquarie, was launched last week while the second, from Commonwealth Bank, is due to open this Thursday.
They are described as “Capital Notes” because they form part of the Bank’s regulatory capital base. They also have debt like features in that they pay a regular quarterly distribution, and in all likelihood, should be redeemed for their $100 face value on the nominated date. However, the latter is not guaranteed.
Capital notes are listed and traded on the ASX. Colloquially, they are categorised as hybrid securities because like a hybrid motor car which is part petrol and part electric, a hybrid security is part debt and part equity. Unlike a share however, the equity part is about possible capital loss, not the prospect of capital gain.
So, should you invest? Here is what you need to know.
1. Capital note distributions have never been lower
Capital notes are floating rate securities. The quarterly distribution varies, and is set at a fixed margin over a benchmark floating interest rate. The benchmark is the 90 day bank bill rate (it is effectively the rate banks lend money to each other for 90 days), which is currently around 0.03%. Yes, you read that correctly………..0.03% pa. This rate varies, and over the last three decades, has been as high as 20.5% and as low as it is today at 0.03%. When the Reserve Bank raises interest rates (it says it won’t be doing this until 2024 at the earliest), it will go up. In the meantime, it shouldn’t move too far from where it is today.
The fixed margin is added to the 90 day bank bill rate to determine the distribution. This fixed margin is the most important consideration with capital notes. CommBank’s Capital Notes, which are called PERLS XIII (meaning the 13th issue of PERLS securities – PERLS is an acronym standing for Perpetual, Exchangeable, Resaleable, Listed Securities), pay a fixed margin of 2.75%. Macquarie’s Capital Notes, Capital Notes 5, pay a fixed margin of 2.9%.
If the 90 day bank bill is 0.03%, the gross distribution on PERLS XIII will be 2.78% (2.75% + 0.03%). If the bank bill rate rises to (say) 1.0%, the gross distribution will be 3.75% (2.75% + 1.0%).
The important word to note here is “gross”. Distributions are franked, but are adjusted for the benefit of the franking credits. In the case of PERLS XIII, the actual distribution in cash is 0.7 times the gross distribution rate. So, if the distribution rate is 2.78%, you will get a distribution in cash of 1.95%. There will also be franking credits worth 0.83%.
(Macquarie’s Capital Notes are a little more complicated because distributions are partially franked. However, the distribution is adjusted for the attached franking credits).
CommBank has been issuing PERLS for almost two decades. The table below shows the issues over the last eight years (each of these issues is still trading on the ASX). Over this period, the lowest fixed margin has been 2.8% (PERLS VII), while the highest margin has been 5.2% (PERLS VIII). The new PERLS XIII is a record low of 2.75%.
CommBank is the prime hybrid securities issuer (most liquid, biggest issues), so 2.75% is also a record low for the hybrid market.
2. The risks of investing in capital notes have never been lower
One of the reasons that the fixed margin on capital notes is so low is that the Banks have never been stronger. Since APRA determined that the major banks must be “unquestionably strong” and have a minimum capital ratio of 10.5%, the banks have raised considerable amounts of capital, divested assets and taken other actions to strengthen their balance sheets. In fact, CBA’s CET1 capital ratio was 12.6% on 31 December, which with divestments in train, rises on a proforma basis to almost 13%.
The more capital a Bank has, the greater the capacity of the Bank to withstand a financial or economic shock, and the less chance that hybrid securities (which can be thought of as loss absorbing securities) will be impacted.
There are other reasons why fixed margins are at record lows including the thirst for income driving the yield on most investments down, and of course, supply and demand. But the improved capital position of the banks is an important reason.
But, there are still risks.
3. There are risks, however
The main risk with capital notes is that the issuing bank gets into financial trouble, or there is an industry wide issue that affects banks, such as the GFC (global financial crisis) of 2008-2010. The risk is capital loss, or that you end up with a security which is not paying a distribution.
Technically, capital notes are perpetual and have no term. They are designed as “loss absorbing securities” such that if the bank gets into trouble, they become permanent capital. They convert (exchange) into ordinary shares.
There are two defined triggers for this exchange, a ‘capital trigger event’ and a ‘non-viability trigger event’. Under these tests, the regulator (APRA) can require the Bank to immediately exchange the capital notes into ordinary shares if the Bank’s Common Equity Tier 1 Capital Ratio falls below 5.125%, or if it believes it 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 ordinary shares as there is a cap on the maximum number of shares that can be issued.
Payment of distributions is also discretionary, non-cumulative and subject to payment conditions. To protect holders from this discretion being miss-applied, the Bank is then restricted from paying a dividend on its ordinary shares.
Capital notes have a mandatory exchange date. For Macquarie, this is in about 9.5 years on 18 September 2030, while CBA’s PERLS XII is in 7.5 years’ time on 20 October 2028. Provided the Bank’s share price has not collapsed, this is the date your capital notes will be exchanged into $101 of ordinary shares. That is, for every $100 capital note, you will get $101 of ordinary shares. Rather than exchange, the Bank can also elect to redeem or repurchase the capital note for $100.
If economic conditions are good and the Bank is travelling ok, a more likely scenario is that the Bank will call the issue early (that is, redeem the issue and give you your $100 back).. Macquarie’s Capital Notes 5 have three call dates (starting on 18 September 2027), while PERLS XIII have a call date in 5.5 years on 20 October 2026.
As floating rate securities, there is no interest rate risk per se on capital notes. If bond rates go up, they won’t be directly affected. However, they are marketable securities impacted by supply and demand factors and the price they are trading on the ASX may be less than or more than $100.
If the fixed margin rises on new issues, older issues with lower fixed margins will be less attractive to investors. So, their price will fall to make them more attractive, with investors being compensated for the lower margin by getting a small capital gain (for example, by buying a capital note for $97 that will one day be redeemed for $100). Conversely, if the fixed margin on new issues falls, older issues with higher fixed margins will trade above par (more than $100)..
Market risk is a meaningful risk with capital notes and hybrid securities. During the Covid-19 market meltdown, hybrid securities were smashed and Lost (very briefly) up to 15% of value. But they recovered, and due to investor demand, now trade on the ASX at higher prices than they did pre-Covid.
4. How do they stack up compared to term deposit or ordinary share?
Term deposits are government guaranteed (up to $250,000 per bank per investor) and are arguably riskless. That’s why the rate is so low – CBA is pay 0.08% for 90 days, 0.2% for 180 days and 0.35% for 12 months. Macquarie is offering 0.40% for 90 days, 0.45% for 180 days and 0.50% for 12 months. These rates are gross.
Like for like, CBA PERLS XIII are paying 2.7% higher than a term deposit, Macquarie Capital Notes 5 are paying 2.5% higher. Not an outstanding “risk premium”, but a comfortable risk premium.
I always struggle comparing capital notes with ordinary shares because the instruments are so very different. There is also a case to think of capital notes as part of the fixed interest allocation, while ordinary shares should be part of the equity allocation.
But, if a comparison on income is required, CBA is trading on a grossed up dividend yield of around 5.7%, Macquarie is 3.9%.
5. Macquarie or CommBank, or both?
Both issues will be well supported. CommBank PERLS XIII is the pick. While its fixed margin is 0.15% less than Capital Notes 5, it is two years shorter, it will be a jumbo/benchmark issue, and CommBank PERELS trade at a premium to Macquarie Bank’s capital notes.
You can learn more about hybrid securities at ASIC’s MoneySmart website (go to https://www.moneysmart.gov.au/investing/complex-investments/hybrid-securities-and-notes). Commonwealth Bank has also developed an interactive module on bank hybrid securities, which is available at www.commbank.com.au/about-us/shareholders/securities/bank-hybrid-securities-basics.html
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regard to your circumstances.
