This article appeared in the March 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.
Learn how to get higher, more reliable yields with interest rate securities.
By Mike Saba, Evans & Partners
Australian fixed-interest markets have been a hub of activity this year despite the European funding crisis increasing volatility in all markets.
Australian interest rates have bounced off two-year lows as global financial markets settle and the Reserve Bank decided in February to leave cash rates stable. Against a backdrop of a weak global economy, a mixed local economy and a signal that the US authorities will keep rates low for some time, local rates appear likely to remain near current levels.
Another repercussion of the European debt crisis has been a marked increase in the cost of funds for Australian banks in recent months. This has implications for their lending ability and the rate they must pay to attract funds. This has led to the banks increasing their borrowings from the local market while raising funds in offshore markets remains difficult.
(Editor's note: Some interest rate securities have terms that investors, who have previously only bought shares, may not be familiar with. To learn about the features, benefits and risks of interest rate securities, do the ASX's free online interest rate securities course. You can also use the ASX Glossary to help understand the 'language' of the interest rate securities market).
Covered bonds launched
In January, the Commonwealth Bank launched the first local covered bond, a type of bond only recently approved for issue by the Australian Prudential Regulation Authority (APRA). A covered bond is secured by assets that are ring-fenced from depositor's claims, which makes it the highest-ranking bond issued by banks.
CBA and Westpac in January issued nearly $7 billion of covered bonds combined, in both fixed rate and floating rate payment styles. With funding in general difficult, the rates paid on the covered bonds were high at margins between 1.65 per cent and 1.75 per cent over reference rates.
A consequence of the high-issue margins of such bonds has been to increase the margins of other bank debt, and indeed the margins for debt of most financial companies. As well, yields on all bank hybrids have subsequently increased in recent months.
Debt and hybrid markets popular
The ASX debt and hybrid markets have also been extremely busy, with investors hungry for yield-type investments. In the last months of 2011, three large hybrid issues by Woolworths, Origin and Australian Foundation Investment Company were listed to strong demand.
This theme has continued in 2012, with the demand partially met with the announcement of issues by Tabcorp, ANZ, Colonial and Westpac. It is interesting that these issues have various structures. The Tabcorp and Colonial issues are long-term subordinated debt, with the issuers incentivised to repay the bonds after five years, otherwise they are penalised by rating agencies that will reclassify the bond on the balance sheet from equity to debt.
Fixed-interest opportunities abound
There has been much selling to fund the new issues, given they total more than $3 billion, and this has resulted in some outstanding buying opportunities in the secondary market.
Three short-term opportunities include: (Editor's note: Do not read the ideas below as securities recommendations. Talk to your financial adviser or do further research of your own before acting on themes below).
1. PERLS IV (CBAPB)
PERLS IV is due to be repaid in October this year, when holders will receive either face value ($200) in cash or this value in shares at a 1 per cent discount. CBA can only delay repayment if its share price is below $32.98, which seems unlikely given the share price is currently close to $50.
Even if the share price is below this level, CBA can still choose to repay the issue in cash with APRA's blessing. If CBA does not repay, the share price test is applied at each quarterly distribution rate. CBAPB must be repaid or converted if the share price is above this level just prior to the applicable date. There are three distributions to go, each approximately $1.86 fully franked ($2.66 including franking value).
From a price of $197 at March 1, these dividends plus the $3 capital gain to repayment at $200 (possibly more if conversion occurs), return a yield of 4.35 per cent without franking, or 6.52 per cent with the franking value. Given there are 244 days from March 1 to repayment at the end of October, these yields respectively give annual yields of 6.52 per cent unfranked and 8.33 per cent including franking.
For reference, an entry price of $198 would give annualised returns of 5.73 per cent (7.53 per cent including franking) and from $199, 4.95 per cent and 6.74 per cent. Simply put, this means good yield from the highly rated CBA with a repayment this October highly probable.
2. Suncorp MCPS (SBKPB)
There is a similar situation with the MCPS from Suncorp; the same senario as CBAPB will play out. In June 2013, if Suncorp's share price is above $7.98 it must repay the preference shares in cash or convert into ordinary shares at a 1 per cent discount. The share price is currently $8.26, which is closer than the comparable CBA test.
Nevertheless, Suncorp can still choose to repay with APRA's blessing or leave the issue in place with the share price test being applied each quarterly dividend date. From the basis of a price of $97.50 on March 1, the annualised yields are 6.93 per cent ungrossed or 9.18 per cent grossed. For reference, from an entry price at March 1 of $98.50, the annual yields are 6.23 per cent ungrossed or 8.47 per cent grossed, and from $100 the annual yields are 5.20 per cent ungrossed or 7.43 per cent grossed.
3. IAG reset convertible preference share (IAGPA)
This preference share is up for repayment or a reset of terms this June. The reset structure is excellent for holders as they have unequivocal repayment rights. The company also has repayment rights or can offer holders new terms (which they don't have to accept, but may be attractive). Upon a holder request for repayment, the company either pays the face value ($100) in cash or converts into shares at a 2.5 per cent discount. Conversion would actually be a good outcome, giving $102.56 of value in shares.
Holders would not have to complete the conversion as the market would recognise this extra value ($2.56) and would bid the preference share price up by at least half the discount. Nevertheless, the yield is very good for the simple $100 redemption, with conversion a bonus. There is one dividend of $2.80 fully franked to go, paid in June.
From a total entry price of $101, the yield-to-maturity is 9.77 per cent annualised including franking (without franking 5.71 per cent). From a price of $101.50, the yield-to-maturity including franking is 8.04 per cent (4.02 per cent unfranked). Adding half of the 2.50 per cent conversion discount would give a yield-to-maturity of 14.06 per cent (9.97 per cent unfranked) from a $101 entry price. This is a great yield, with options of extra value from conversion or choice to take new terms.
About the author
Michael Saba is Head of Derivatives at Evans & Partners in Melbourne and a leading analyst.
ASX Interest Rate Securities provides good information for those who want to learn more about fixed-income products, such as:
- Corporate bonds
- Floating notes
- Convertible notes
- Hybrid debt securities.
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