CBA hybrid looks cheap

Today I write that it's not often you come across a major bank hybrid that is genuinely cheap, which CBA’s new Perls XI preferred equity security (ASX: CBAPH) undeniably is given an expected maturity (or “call” date) of 5.36 years (click on that link to read the full column or AFR subs can click here). Brief excerpt only:

We chose not to invest in Westpac’s $1.69 billion WBCPH offer in February, which had a 7.5 year call date, and CBA's terribly timed, 7.0 year CBAPG security in March that raised $1.37 billion. WBCPH was priced 0.20 percentage points inside the ASX preferred equity curve before any new issue concession, which investors should demand in the same way equity issues normally price at a discount to their secondary value.

While in the major banks’ senior bonds the new issue concession is ordinarily 0.03 to 0.05 percentage points, which is what NAB paid for a deal on Thursday, we like to see 0.20 to 0.40 percentage points in higher volatility debt and hybrid trades.

This was the case when Westpac’s treasurer Curt Zuber priced a new tier two (T2) subordinated bond earlier in the year 0.25 percentage points above prevailing spreads, which has unsurprisingly performed strongly in the period since.

The same cannot be said for the congested bungle that was the month-on-month major bank issues in the first quarter with WBPCH and CBPAG trading as low as $95.59 and $97.03 as a conspiracy of headwinds, including excess supply, fears around trade wars, franking, and other geo-political dramas, pushed spreads wider.

The only hybrid deal that we have bought in 2018 has been Macquarie’s MQGPC offer, which has performed brilliantly, leaping to $104.93 post-issue.

CBA’s new treasurer Terry Winder has appropriately balanced the tension between managing his cost of capital and meeting the needs of savvy creditors. Prior to news of CBAPH being leaked by Street Talk on October 10, the ASX curve for a 5 year major bank hybrid was at 3.39 percentage points above the 3 month bank bill swap rate (BBSW). On this basis, Winder is offering investors a circa 0.25 to 0.30 percentage point concession.

Once markets get a sniff of a pending deal, selling ensues and the 5 year major bank curve duly moved out to 3.66 percentage points following Street Talk’s item. Even if we ignore this distortion, Winder is still offering investors a concession with the proposed 3.7 percentage points margin, which translates into a grossed-up running yield of 5.6 per cent annually or an unfranked cash yield close to 4 per cent. This is also wider than the average 5 year major bank hybrid spread of 3.62 percentage points since 2012 and multiples the 1.25 percentage point spread CBA paid on its 2007 Perls hybrid when its core equity ratio was just 4.78 per cent (less than half its current level).

There are several other reasons why I rate CBAPH. The first is that it should not be especially large with Morningstar’s John Likos forecasting a total issue size of only $1.25 billion. CBA partly refinanced the hybrid CBAPH will replace, the $2 billion Perls 6 security (CBAPC), with its CBAPG offer in March. Care of the $4.13 billion sale of its funds management business, CBA will also be carrying significant excess equity, alleviating pressure to boost its additional tier one (AT1) hybrid buffer. And Winder is understood to be looking at tapping the US dollar hybrid market in the future, which will reduce his ASX requirements...

Another constructive dynamic is the fact that Standard & Poor’s Sharad Jain has said the rating agency is considering upgrading Australia’s economic risk score, which would lift CBA and Westpac hybrid ratings from BB+ to the “investment grade” BBB- mark that will liberate more institutional demand. S&P has already presciently upgraded the sovereign’s AAA rating’s outlook from “negative” to “stable” on our forecast of the budget’s return to surplus in 2019, above-trend real GDP growth, a decline in the jobless rate towards its “full employment” 5.0 per cent level, and the predictable unwinding of housing imbalances.

A final consideration is that APRA has revealed it is contemplating migrating the major banks’ capital ratios to a “globally harmonised” standard, which would boost CBA’s circa 11 per cent equity ratio to around 16 per cent. This would avoid the current confusion banks face when they raise money offshore and have to explain to investors why their capital ratios look ordinary even though they unambiguously rank among the best capitalised banks in the world once you standardise these metrics.

Here APRA has canvassed the possibility of retaining the equity conversion triggers in bank hybrids at their current 5.125 per cent level, which is in line with best practice overseas. This would level the competitive playing field while giving APRA greater regulatory flexibility to remediate a struggling bank without risking the catastrophic contagion associated with bailing in hybrids and bonds. If APRA adopts this approach, the equity buffer protecting hybrids will double from about 5 to 10 percentage points, reducing the probability of loss and the returns required on these securities.

Read the full column here.