Stock Review

Yield slippage in ANZ CPS2 offer

13/11/2009

  • Company: ANZ CPS2 (ANZPA)
  • Recommendation: Avoid
  • Price at Review: $100.00
  • Current Price: $101.60
  • Fundamental risk: 1.5
  • Share price risk: 2.5
  • Category: FLOAT

While ANZ CPS2 is the next bank preference share to roll off the production line, the possibility of outlier events still worries us.

When an offer to participate in the next new float of an income security, hybrid or preference share lands in your letterbox, it’s the yield that tends to draw the eye (go on, admit it). But a concerted effort to consider the risks is also necessary.

If you buy an income security or preference share at full face value, the upside is capped; you’re never going to get more than the heavily advertised rate. But the downside is large – you could lose 100% of your capital. So if you’re going to pay full price (as you tend to in a float), you must make sure it’s a very secure instrument or that it offers a high enough yield to compensate for the various risks.

The issue of ANZ CPS2, ANZ Bank’s latest issue of convertible preference shares, follows in the trail of the Westpac SPS II offer and the CBA PERLS V offer. Although this offer has some differences, the key concepts are similar.

Much like layers of rock reveal the past to a geologist, differing rates from these issues provide a chronological record of improving credit markets over the course of this year. ANZ CPS2 are offering a fully franked distribution which, when ‘grossed up’, equates to the 90-day bank bill rate plus a margin that will be set somewhere between 3.1% and 3.3%, depending on institutional demand. That compares with 3.8% for the SPS II issued in March, and 3.4% for the PERLS V issued in September.

Important details
Issue price $100.00
Securities on issue 7.5m+
Distribution rate (grossed up) 90-day BBSW plus 3.1-3.3%
Current 90-day bank bill rate 4.06%
Closing date 10 December
Listing date 18 December
Mandatory conversion 15 December 2016

The rate certainly still beats what you’ll get in a bank account. But as we explained in our PERLS V float article, that’s not necessarily the comparison you should be making. These securities are riskier than cash in the bank. Our key concerns are summed up in the first few pages of the offer document.

On page 9, ‘CPS2 rank ahead of Ordinary Shares … but behind all senior ranking securities or instruments, and all depositors and other creditors.’ If ANZ ever does get into trouble, these securities will behave more like equity than bank deposits.

As we explained in Clamming up over PERLS V (and so won’t go into too much detail here), ANZ CPS2 are also classified as ‘Non-innovative Residual Tier 1 Capital’. That means that APRA is confident that, if the proverbial does hit the fan, this instrument won’t have any ability to force the bank into administration. That’s good for the bank and for APRA’s ability to keep it solvent, but not for CPS2 holders if they end up sitting in the creditors’ queue.

The odds of a major Australian financial institution imploding are pretty slim, but ANZ is our least preferred big bank due to its aggressive offshore expansion plans, which increases the discomfort level a notch.

Another concern

Page 10 includes the now common but still disappointing caveat that distributions are payable at ‘absolute director discretion’ and are also subject to a ‘specific APRA payment tests’. In other words, the directors or APRA can choose to stop distributions. This is an important attribute for achieving the Non-innovative Residual Tier 1 Capital status we referred to earlier. Considering any such skipped distribution is ‘non-cumulative’, it would be lost forever.

Ben Graham’s wisdom

‘The typical preferred stockholder is dependent for his safety on the ability and desire of the company to pay dividends on its common stock. Once the common dividends are omitted, or even in danger, his own position becomes precarious, for the directors are under no obligation to continue paying him unless they also pay on the common. On the other hand, the typical preferred stock carries no share in the company’s profits beyond the fixed dividend rate. Thus the preferred holder lacks both the legal claim of the bondholder (or creditor) and the profit possibilities of a common stockholder (or partner).’

Benjamin Graham, The Intelligent Investor (first published in 1949); chapter 4.

There’s still an argument to be made in favour of purchasing these securities. It’s highly likely that they’ll pay every distribution scheduled over the next seven years until they convert into ordinary ANZ shares on the so-called ‘mandatory conversion date’ in late 2016. We say ‘so-called’ because the mandatory conversion date is subject to mandatory conversion conditions, and may not actually occur in 2016.

Most brokers will probably recommend the float (the retail brokerage fee of 1% they’ll collect might help their decision), and their clients are unlikely to be greatly upset come 2016.

But just because this security has an expected term of seven years doesn’t mean Most Bankings should ignore the risks of 1-in-20 year and 1-in-100 year storms. In taking on something approaching an equity-like risk, we want a more equity-like return. We’ll reconsider our position if the CPS2 ever trade at a meaningful discount to face value, but for now we say AVOID.

Disclosure: Staff members own ordinary shares in ANZ Banking Group, Commonwealth Bank and Westpac Banking Corporation, but they don't include the author, Gareth Brown.


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