Why CBA Hybrid Might be Attractive

In my AFR column I speculate that sanity could prevail and the mooted CBA hybrid that is expected to be launched next week could actually be attractive, offering a much higher margin and shorter maturity than Wesptac's latest issue (ASX: WBCPH) (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"On the basis of current spreads with equivalent repayment dates, WBCPH should trade at around $98.10, or 1.9 per cent below its issue price. Alternatively, there is the possibility brokers bid up WBCPH's price for a day or two to avoid a client backlash or that the market undergoes a rally that suddenly makes WBCPH look cheap. On an outright, bottom-up basis we do, to be clear, believe that WBCPH is attractive, which is a point I will return to later. The question right now is what would be a reasonable return for CBA to offer on its new security. We know that fair value for the 7.5-year WBCPH was 3.43 per cent above the bank bill rate. Elevated secondary churn has pushed this fair value benchmark to around 3.52 per cent. Tonucci could reasonably argue that February's price action is a temporary dislocation that has distorted valuations. To galvanise strong interest, he might consider offering both a better margin than WBCPH and a shorter call date. With this in mind, fair value for a seven-year major bank hybrid immediately prior to WBCPH being announced was 3.40 per cent. Tonucci could also argue (as Westpac did) that his new deal allows investors to avoid the brokerage and wide bid-offer spreads they would otherwise pay in the illiquid secondary market. There is certainly a case that issuers of large-volume deals north of $1 billion can trade off the conventional interest rate premia against the liquidity and cost benefits their transactions afford. And there is compelling evidence that ASX hybrids are, in fact, cheap relative to where global investors would price them assuming they can harness franking credits. In the over-the-counter US dollar hybrid market, which is an exclusively institutional domain, a seven-year additional tier one capital security with a BB+ rating (identical to the major banks' hybrids) only commands a 2.6 per cent risk premium above the US bank bill rate. Swapped back into Aussie dollars, this translates into about 2.9 per cent above our bank bill rate, which is miles below ASX spreads. We also value CBA hybrids on a "bottom-up" basis, accounting for its asset, liabilities, leverage and equity volatility to estimate a probability of default and minimum required risk premium. Blowing out CBA's historic probability of default by one standard deviation to a lofty 17 per cent, and assuming a zero per cent recovery rate, we get fair value spreads for five-year and seven-year CBA hybrids of 2.5 per cent and 2.7 per cent, respectively, above the bank bill rate. This happens to coincide with where five-year major bank hybrids traded in mid-2014. Since that time, our biggest banks have significantly enhanced their equity buffers, reduced leverage and de-risked their businesses by selling non-core assets, which are all credit positive for hybrid holders notwithstanding that spreads are currently 100 basis points wider than their 2014 nadir.  (For what it is worth, our 17 per cent probability of default is also much more conservative than the 12 per cent cumulative default probability Moody's has documented on BB+ securities since 1984.) There are two other technical factors to contemplate. First, it is unlikely we will see much more hybrid supply for the remainder of the year. Indeed, CBA may refinance its CBAPC security, which is due to be called in December, with an inaugural over-the-counter deal for which I suspect there will be considerable demand. And Tonucci may decide to sensibly cap next week's deal size. One of the biggest fears investors have is that issuers supply too many securities, as CBA did with its $3 billion Perls 7 deal, which makes it difficult for them to perform in the secondary market. Clearly telegraphing a maximum deal size, and scaling investor bids back, would create more favourable demand and supply dynamics. A final point is that CBA is our preferred credit among the major banks given its multi-decade track record of avoiding the extreme loan losses, offshore blow ups and solvency crises that have plagued ANZ, NAB and Westpac." Read the rest of the article here.