Meet CBA’s new bank hybrid with bite

Income Asset Management Group’s Director of Credit Strategy, Matthew Macreadie unwraps the brand-spanking latest CBA Tier 1 capital opportunity and why the smart play involves a Tier 2 offset.

Investors who like CBA should be aware there are two promising portfolio construction options now on the table.

In volatile times there’s still a case for owning bank hybrids, however investors should be aware that hybrids and Tier 2 bonds offer strong risk/return potential which is why it makes sense to first consider building an adequate allocation to both asset classes.

Here’s my suggested approach:

At IAM, we’re advocating investors adopt a diversified portfolio with adequate exposure to Tier 2 bonds alongside hybrids – particularly in today’s environment, where we advise an emphasis on downside protection in these times of intense market turbulence.

The Commonwealth Bank of Australia (ASX: CBA) this week launched an offer for its CommBank PERLS XV Capital Notes (expected ASX Code: CBAPL), to raise $750 million, with the ability to raise more or less.

The CBAPL has been priced at a margin of 2.85% over 3m Bank Bill Swap Notes (BBSW) with a call date of 5.6 years. This call date is an expected maturity and hybrids do run the risk of being perpetual instruments if not called.

PERLS XV have an Initial Face Value of A$100 and will qualify as Tier 1 Capital of CBA.

These securities are structured as perpetual, subordinated, unsecured and convertible notes. Distributions are discretionary, non-cumulative, floating rate and expected to be fully franked, paid on a quarterly basis in arrears until converted or redeemed.

3m BBSW is currently 2.94% (20/11), thus, the running yield on CBA’s hybrid would be 5.79% (margin of 2.85% over 3m BBSW).

CBA’s current gross dividend yield is 5.47% (20/11) – hence CBA’s hybrids stacks up well against CBA’s dividend yield.

And remember, both are grossed-up for franking credits.

Know your credit spreads

For some context, let’s first examine CBA’s recently issued Tier 2 in April 2022.

There was a floating and fixed leg which priced at a margin of 1.90% over 3m BBSW and S/Q ASW respectively. This had a call date of 5 years with a final maturity of 10 years. Tier 2 sits higher up in the capital structure (vs hybrids which are Tier 1), have higher credit ratings (BBB+ vs BBB-) and no conversion to equity if a bank’s CET1 <5.125%.

The key is that while bank hybrids are trading at credit spreads inside their historic levels, the contrary is true for Tier 2 securities. For example, the trading margins on CBA’s floating and fixed leg show credit spreads at 2.35% and 2.20% respectively (importantly, which is wider than historic levels).

Furthermore, CBA’s Tier 2 security has been outstanding for 6 months already and so there is only 4.5 years to the call date.

Using the AUD interpolated swap curve, we can extrapolate the yield to call for the two floating rate CBA securities (Tier 2 versus Tier 1).

As shown below, the yield to call between the CBA hybrid and the CBA Tier 2 (whether floating or fixed) is not too dissimilar. But we do know the risks between hybrids and Tier 2 are different especially in the current market conditions.

Note: Bloomberg Levels. IAM execution prices/yields may vary.

Credit where credit’s due

The current returns from hybrids do look on the expensive side on a risk-reward basis. The yield to expected maturity/first call on hybrids is around 7% (franked) not too dissimilar from Tier 2 at a high 6% (unfranked).

CBA remains a very good credit.

The country’s largest lender has, for many years, achieved superior returns through sound management of risks and costs while maintaining relatively high-profit margins.

CBA has a leading position in mortgages and deposits and is challenging NAB in business banking. Asset quality is stellar and capital is robust, which is helpful for the bank as property prices start to decline.

For investors wanting to earn a high 6% with considerably less price risk, Tier 2 offers the perfect shock absorber alongside hybrids.

Best of all, the sacrifice in yield is minimal to give an investor the ability to sleep better at night. The alternatives to hybrids have never looked this good.

Matthew Macreadie is Director of Credit Strategy at Income Asset Management.

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