Commonwealth Bank has announced details of a new ‘hybrid’ securities issue – PERLS VI – which looks set to be reasonably well accepted by the market.

PERLS VI (which stands for the sixth issue of Perpetual Exchangeable Resaleable Listed Securities) are called hybrids because they share the qualities of bonds and stocks; that is, they start out paying quarterly interest similar to a bond, but then may be cashed in or converted to ordinary shares at a later date.

The issue is being made to refinance Commonwealth Bank’s earlier PERLS IV issue and otherwise fund its business. It will count as Tier 1 capital for the bank (that is, the core capital used by regulators to judge a bank’s financial health).

This is the first issue by a major bank that is fully compliant with the Australian Prudential Regulation Authority’s (APRA) new rules for Tier 1 capital under the global Basel III regulatory standard, so it’s a little more complex than previous issues.

The details

PERLS VI will pay a quarterly fully franked floating distribution. The distribution is set each quarter at a fixed margin over the benchmark 90-day bank bill rate, and then adjusted for the company tax rate (to take into account the franking credit benefits). The indicative margin for this issue is in the range of 3.80% to 4.00%.

The 90-day bank bill rate is currently around 3.6%, implying a gross distribution rate of 7.4% per annum for the first quarter (i.e., 3.6% + 3.8% = 7.4%). The actual distribution in cash, which is fully franked, would be:

7.4% x (1 – Company Tax rate) = 7.4% x 0.7 = 5.18% pa.

As distributions are fully franked, the first quarter distribution for an SMSF in the ‘accumulation phase’ will be equivalent to an after-tax return of 6.29% a year. For an SMSF in the ‘pension phase’, the after tax return will be 7.4%.

These Notes are ‘perpetual’, meaning they and have no term, so Commonwealth Bank

(CBA) must (subject to a test) exchange the notes for ordinary shares on 15 December 2020 – just over eight years away.

Details of the issue are as follows:

The institutional book build next Monday will set the final margin.

The fine print

If the exchange occurs, note holders are issued ordinary CBA 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. The exchange will occur provided the shares are higher than approximately $30, otherwise, it is retested on the next and subsequent distribution dates until the test is met.

In order to qualify as Tier 1 capital, Commonwealth Bank has included two further exchange triggers – a ‘capital trigger event’ and a ‘non-viability trigger event’.

Under these tests, APRA can require the bank to immediately exchange the notes for ordinary shares if CBA’s Common Equity Tier 1 Capital Ratio falls below 5.125% (the ratio was 7.82% as at 30 June 2012), or if APRA believes the bank needs an injection of capital to remain viable. Due to a cap on the maximum number of shares that can be exchanged, a note holder could receive less than $100 of shares under these scenarios.

Distribution payments are discretionary and subject to Commonwealth Bank having sufficient ‘Distributable Profits’. The payments don’t accrue if not paid.

The main protection note holders have is that if a distribution isn’t paid, a dividend stopper is placed on CBA ordinary shares.

Leaving aside the features that allow these notes to be classified as capital, Commonwealth Bank also has a once-only call option on 15 December, 2018 (in just over six years). On this day, the bank can elect to effectively redeem the notes by paying holders the face value.

Our view

While a complex issue structure, this is after all the Commonwealth Bank. The market will be assuming that the issue will be called in December 2018, or in the worse case, converted into ordinary shares in 2020.

The indicated margin of 3.8% to 4% is a little higher than had been rumoured, perhaps reflecting a slightly tougher borrowing market for our major banks. The CBA PERLS V issue (CBAPA), which is due to be exchanged (or effectively redeemed) in October 2014, is trading at a price of $201.65. With an accrued distribution of $1.09, this is trading at a margin of 90-day bank bill plus 3.35%. PERLS V doesn’t have the capital trigger or non-viability trigger events, and only has two years to run. That said, if the PERLS V secondary market price is a guide, the PERLS VI issue looks relatively attractive.

Bottom line – this issue should be reasonably well sought after at the bottom of the indicated margin band of 3.8%. Expect the issue size to be increased to at least $1.5 billion.

Important information: 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. Anyone should consider the appropriateness of the information in regards to their circumstances.