In its release for the half-yearly results last week, CBA said that it was “considering the issue of a Tier 1 capital instrument to replace PERLS III should markets be receptive.” Market chatter suggests that the bank is close to making a decision and may, in fact, announce a new hybrid issue later this week.
The $1.1 billion PERLS III issue is a hybrid security that was issued in March 2006 and pays a margin of 1.05% on top of the 90 day bank bill rate. At present this represents a gross total of around 3.30% (ie: including franking credits). PERLS III can be redeemed by the bank on 6 April 2016 and should they not do so investors will receive an additional one-off ‘step-up’ margin of 1.00%.
If the bank were to redeem the hybrids and issue new hybrids, it would be at a massively different margin to the PERLS III and to the PERLS VII that were issued in October 2014 at BBSW + 280 basis points – a peak in the investor frenzy for yield. The PERLS VII polarised the market as they were issued at what was a post-GFC low margin. The appetite was so strong that CBA issued $3 billion worth, leading to huge indigestion for investors who then shied away from other hybrid issues for some time. The PERLS VII issue was great for CBA but has been a dud for investors. It has never traded above its issue price of $100 and presently trades around $86.05 per $100 face value. The trading margin is now around 540bps, or around double the margin at which they were issued at. The outcome is any investor which bought on them via the issue is nursing a significant investment loss and holding an investment which is paying well under current market rates.
So the question is why would CBA buy the PERLS III back? Markets expect banks to redeem at the first opportunity but it represents cheap funding for the bank, even if the step-up clause is enacted. Step-up securities as they are known were designed to give the issuing banks an incentive to redeem and since the Basel III reforms have been announced, banks not redeeming step-ups on the first call date are unable to use the funds as Tier 1 capital. So the answer is not clear cut but it does rely heavily on the bank managing the reputational issue of failing to redeem, which is what most investors expect them to do.
There is a chance the bank may redeem the PERLS III and not issue new hybrids to replace them. This would mean the bank’s Tier 1 capital level falls from around 10.2% but it would still be comfortably above the minimum level set by APRA.