Matthew Macreadie, director of credit strategy at Income Asset Management Group, unveils the ABC’s latest Tier 1 capital opportunity and explains why smart play involves Tier 2 compensation.
Investors who love the ABC should know that there are currently two promising portfolio construction options on the table.
In times of volatility, it is still possible to own bank hybrids, but investors should be aware that hybrids and Tier 2 bonds offer high risk/return potential, which is why it makes sense to consider investing. first to construct an adequate allocation to the two asset classes.
Here is my suggested approach:
At IAM, we advise investors to adopt a diversified portfolio with adequate exposure to Tier 2 bonds alongside hybrids – particularly in the current environment, where we advise emphasizing downside protection in these times of severe market turbulence.
The Commonwealth Bank of Australia (ASX: CBA) this week launched an offering for its CommBank PERLS XV Capital Notes (expected ASX code: CBAPL), to raise $750 million, with the option to raise more or less.
The CBAPL was set at a margin of 2.85% on 3 million Bank Bill Swap Notes (BBSW) with a call date of 5.6 years. This call date is an expected maturity and hybrids run the risk of being perpetual instruments if they are not called.
PERLS XV has an initial face value of AU$100 and will be considered CBA Tier 1 capital.
These securities are structured as perpetual, subordinated, unsecured and convertible notes. Distributions are discretionary, non-cumulative, floating rate and are expected to be fully franked, paid quarterly in arrears until converted or redeemed.
3m BBSW is currently at 2.94% (20/11), so the running yield on the CBA hybrid would be 5.79% (2.85% margin on 3m BBSW).
CBA’s current gross dividend yield is 5.47% (20/11) – therefore CBA hybrids compare well to CBA’s dividend yield.
And remember, both are marked up for postage credits.
Know your credit spreads
For some background, let’s first look at Level 2 recently released by the ABC in April 2022.
There was a floating and fixed leg with a margin of 1.90% on 3m BBSW and S/Q ASW respectively. This had a redemption date of 5 years with a final maturity of 10 years. Tier 2 sits higher in the capital structure (compared to hybrids which are Tier 1), has higher credit ratings (BBB+ vs BBB-) and no conversion to equity if a bank’s CET1
The key is that while bank hybrids are trading at credit spreads within their historical levels, the opposite is true for Level 2 securities. For example, the trading margins on the floating and fixed legs of the CBA show credit spreads at 2.35% and 2.20% respectively (which is significant, which is wider than historical levels).
Also, CBA Level 2 security has been in progress for already 6 months and therefore only 4.5 years left until the call date.
Using the AUD interpolated swap curve, we can extrapolate the yield to call the two floating rate (Tier 2 vs. Tier 1) CBA securities.
As shown below, the yield to be paid between hybrid CBA and CBA Tier 2 (whether floating or fixed) is not too different. But we know that the risks between hybrids and Tier 2 are different, especially under current market conditions.
|ABC Hybrid||ABC level 2|
|Coupon||2.85% on 3m BBSW||1.90% on 3m BBSW||4.95%|
|give in to the call||7.30%||6.75%||6.57%|
Note: Bloomberg levels. IAM execution prices/returns may vary.
Credit where credit is due
Current hybrid yields look expensive on a risk-reward basis. Yield to expected maturity / first call on hybrids is around 7% (stamped) not too different from Tier 2 at a high 6% (unstamped).
CBA remains a very good credit.
The nation’s largest lender has for many years achieved superior returns through sound risk and cost management while maintaining relatively high profit margins.
CBA holds a leadership position in mortgages and deposits and challenges NAB in corporate banking. Asset quality is excellent and capital is strong, which is helpful for the bank as property prices begin to decline.
For investors looking to earn 6% with considerably less price risk, Tier 2 offers the perfect shock absorber alongside hybrids.
Best of all, the yield sacrifice is minimal to allow an investor to sleep better at night. Alternatives to hybrids have never looked so good.
Matthew Macreadie is director of credit strategy at Income Asset Management.
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