It has been a horrific start to the year for the hybrid securities market, with a very thin secondary market exaggerating the price falls. To keep pace with rising dividend yields on bank ordinary shares, bank hybrid securities have come down in price, while subordinated notes from issuers, including Origin and Crown, have also suffered heavy falls.
Last Tuesday, the Commonwealth Bank announced a new issue of capital notes, PERLS VIII. Set to pay a margin of 5.20% over the 90-day bank bill rate, the issue was slammed by some commentators as being “opportunistic”, and that there was better value to be found in the secondary market.
The commentators pointed to some older bank hybrid issues trading on the ASX, with call dates earlier than the PERLS VIII date of 15 October 2021. Typically, hybrid issues are priced on the assumption that they will be called by the issuer (investors will be repaid their $100) on the first available call date, although there is no obligation for the issuer to do so.
The commentators were right for a day or so, but as is often the case, supply creates its own demand and hybrid prices rallied strongly last week – taking most of the older hybrid securities back to around the 5.2% trading margin (see table below).
They also missed a couple of other key points. Firstly, the secondary hybrid securities market on the ASX can be really thin, and buying volume without moving the price higher can be very difficult. Next, there is no obligation to call an issue, with a key factor for the issuer being the cost of replacing any such capital. If an issue is trading in the secondary market at $90, it is very unlikely to make much sense for an issuer to pay $100 to call. Hence, the lower the issue margin, the less likely it is that an issue will be called. For example, the PERLS VII issue, which was issued with at a margin of 2.8%, is less likely to be called (given the new issue margin of 5.2%), and arguably, should trade at a higher margin.
Finally, for the real pessimists, another factor to consider is how far away the price of the ordinary bank share is from the mandatory hybrid trigger price. If the issuer doesn’t call the issue, hybrid securities are exchanged for ordinary shares on the mandatory exchange date (in the case of PERLS VIII, 15 October 2023). However, they must meet a condition for the exchange to start – the current bank share price must be no lower than 56% of the price of the bank share when the hybrid security was first issued. If it doesn’t, no exchange occurs and potentially, the hybrid security continues indefinitely. In the table below, the NAB hybrid (NABPD) would not be exchanged in the NAB share price was to fall by 26.2%.
The table below shows 6 leading hybrid securities. Except for the PERLS VII issue, all have call dates before the new CBA PERLS VIII issue. Prices and trading margins are as per the COB on Friday.
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PERLS VIII Capital Notes
PERLS VIII Capital Notes will pay a quarterly distribution, which is set at a fixed margin of between 5.20% and 5.35% over the 90-day bank bill rate, and then adjusted, for the company tax rate (to take into account the franking credit benefits). The final margin will be set in an institutional bookbuild tomorrow.
With the 90-day bank bill rate around 2.25%, this implies a gross distribution rate of 7.45% pa for the first three months (2.35% plus 5.20%). The actual distribution in cash, which is fully franked, would then be 5.22% (7.459% x 0.70 = 5.22%).
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 miss-applied, if a distribution is not paid, CBA is then restricted from paying a dividend on its ordinary shares.
Exchange into CBA shares or early repayment
PERLS VIII are perpetual and have no term. However, CBA must (subject to a test) exchange the Notes into ordinary shares on 15 October 2023 (in about 7.5 years). If exchange occurs, holders are issued CBA ordinary shares at a 1% discount to the then weighted average market price.
The test for the exchange is the price of CBA ordinary shares at the time – provided they are higher than approximately $41.50, exchange occurs – otherwise, it is retested on the next and subsequent distribution date(s) until the test is met.
To qualify as Tier 1 capital, there are two further mandatory exchange events – 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 VIII into ordinary shares if CBA’s common equity capital ratio falls below 5.125% (the ratio was 10.25% as at 31/12/15), 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 ordinary shares that can be issued
Commonwealth Bank also has an option to redeem the Notes in approximately 5.5 years’ time on 15 October 2021. It can call the Notes by paying holders $100 per Note.
Details of the issue are as follows:
Our view
As has been shown recently, there is nothing to suggest that hybrid-trading margins have necessarily peaked. This is still an attractive market for banks to raise capital in, and if the CBA issue gets away, it is likely that other major banks will follow suit.
The 5.2% margin is, however, a record for a major bank to pay.
On a risk-adjusted basis, a running yield of 7.45% for PERLS VIII doesn’t look too bad against the equivalent bank ordinary share yield, which in CBA’s case, is a grossed up 8.15%.
And if you are investing via a broker or financial planner, most are receiving a placement fee of 1% and, in some cases, will be willing to share some or all of this with potential investors.
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 regards to your circumstances.
