Matthew Macreadie
Investors who like CBA should be aware there are two good portfolio construction options that exist on the table.
There is a case for still owning bank hybrids. However, investors should be aware that hybrids and Tier 2 offer good risk/return. For these reasons, it would make sense to have an adequate allocation to both asset classes. Our suggested approach would be to adopt a diversified portfolio with adequate exposure to Tier 2 bonds alongside hybrids. Particularly in today’s environment, where we place an emphasis on downside protection during market turbulence.
CBA’s recently issued hybrid (ASX: CBAPL) or PERLS XV has priced at a margin of 2.85% over 3m BBSW with a call date of 5.6 years. This call date of 5.6 years is an expected maturity and hybrids do run the risk of being perpetual instruments if not called.
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. Remember, both are grossed-up for franking credits.
In contrast, let’s 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.
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 high 6% (unfranked).
CBA remains a very good credit. It has for many years achieved superior returns through sound management of risks and costs while maintaining relatively high-profit margins. It 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. 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.
