Tuesday 23 February 2016 by FIIG Securities FIIG Securities Opinion

CBA hybrid barely treading water

Published in The Australian

Is the price right? That’s the question being asked by retail investors as CBA launched its new Basel III compliant hybrid

This is the first financial institution hybrid of 2016 and we expect more over the next 12 months. Recent poor hybrid performance has demonstrated that prior issues were cheap funding for the banks and the institutions that shied away from the market were right to do so.

This is highlighted in the new, high issue margin of Perls VIII at 5.20 to 5.35 per cent above the benchmark, around 85 per cent higher than the 2.8 per cent margin offered under Perls VII, which is some price jump! The predicted overall yield on the Perls VIII, assuming the benchmark BBSW is 2.28 per cent is between 7.50 and 7.65 per cent.

In the time between the two issues, much has changed. Almost from day one, Perls VII began trading sub-par and this week was priced around $85, a dreadful result for retail investors trying to survive in a low interest rate environment.

The cost for banks to raise funds in international markets across a range of debt securities, senior and subordinated bonds and hybrids has been rising. So banks have been paying more.

Further, this month we had an example of what happens if things start to unravel. Global German giant, Deutsche Bank, was thought to have insufficient liquidity to pay the distributions on their CoCos, the European version of hybrids more commonly known as contingent convertibles. The price of the CoCos fell from $95 in January to just $70 and the corresponding yield climbed from 7.5 per cent to 13 per cent, displaying the possible sharp turn in market sentiment on the chance that the distribution might be missed.

The Cocos have since recovered to $80 as Deutsche reassured the markets by announcing a buyback of senior bonds to demonstrate its liquidity. However, the ride for European investors has been volatile. Like Australian investors, Europeans have also been driven by low yields, to buy riskier securities, to generate income and this has seen large investment by institutions and retail investors in CoCos.

However, gradually investors are appreciating the complexity and inherent risks in the investments, reducing exposure and demanding higher returns for the risk involved. Perls VII marked the recent low point for hybrid margins which have since then climbed to this new high from Australia’s largest bank. But is it enough?

We are of the view that the margin is still too skinny for the following reasons.

  1. When the deal came to the market, existing hybrid securities offered better value for shorter call dates with yields of 8.0 to 8.4 per cent available with the major banks.
  2. Investors should be paid a premium to purchase a new security over existing securities. In the case of CBA, this would require greater than BBSW + 5.80% which is where the Perls VII were trading.
  3. Institutional investors still prefer the risk and reward offered by senior or subordinated bonds, and eschew hybrids at these levels. 
  4. International spreads on similar securities from a similarly rated bank are higher. A US denominated security with a call date of 30 March 2025 is trading at a spread of 5.49 per cent, while a Euro and GBP issue are trading in the mid 7 per cent range.

Assuming the lower yield of BBSW +5.20%, the Perls VIII are more attractive than previous issues and this reflects the markets’ greater understanding of the risk of these complex securities. They are, after all, purposely designed by the regulator to be ‘loss absorbing’, and it is encouraging that the market has moved to more closely reflect the risks, some of which include: non-payment of distributions or interest, possible failure to be called or repaid at the first opportunity, becoming perpetual investments, that the banks breach minimum capital ratios or the regulator considers the bank ‘non-viable’ and the hybrids convert to shares at the worst possible time and the possible volatility of these complex investments.

While the margin will be attractive to investors, CBA will need to rely on the strength of its brand to get investors to commit with similar hybrid issues already trading at higher margins.

Investors who decide that the new deal offers the necessary income and view CBA as low risk should be prepared for volatility if markets or conditions change.