Stock Review

Buy original PERLS, not the pretenders

6/05/2005

    Company Price at review Current price Fundamental risk Share risk Our view
    APA Group (APA) $203.85 $6.10 1 1 Buy for Yield
    Commonwealth Bank (CBA) $203.85 $74.74 1 1 Buy for Yield
    CBA PERLS V (CBAPA) $203.85 $202.08 1 1 Buy for Yield

    These income securities have fallen in price over the past coupl eof years and, with rising rates, could prove a handy addition to your portfolio.

    ‘Next to being shot at and missed, nothing is quite as satisfying as an income tax refund.’ So said humorist F J Raymond, and while we can think of a few experiences that are a little more satisfying than receiving a tax refund, Raymond’s point stands. No one likes handing over a slice of their income to the government and there’s an element of joy in receiving some of it back.

    So when we recommended two floating rate notes in issue 171/Mar 05, some readers may have been a little disappointed that the attractive rates on offer were not franked. This may be true, but all that ultimately matters is the number of dollars that land in your bank account after any tax is paid tax. If the returns are good enough, then you might be better off even after paying some tax. (Our Investor’s College article of issue 147/Mar 04, titled Dividend franking explained, goes through some calculations you can do to compare fully franked dividends with those that are partly franked, or completely unfranked.)

    However, we know that some people have such a dislike of physically paying tax that they’d opt for a fully franked return over an unfranked one, even if it meant fewer dollars in their pocket at the end of the day. In hunting around for an income security that might satisfy such franking-focused readers, we’ve come up with Commonwealth Bank’s Preferred Exchangeable Resettable Listed Shares (PERLS).

    In fact, with the stock now down 5% from its high of $214 (which is a meaningful amount for this type of security), we think it offers even better value than the WINS and PARS we reviewed last month. But before getting into that, let’s wade through the details.

    PERLS began trading on the ASX in April 2001, back when income securities were really in vogue. They’re a non-participating preference share, which means that their owners do not share in any increase in the Commonwealth Bank’s prosperity. On the flip side, should CBA get into serious financial trouble, PERLS holders stand before shareholders in the wind-up queue, although it should be noted that they stand behind everybody else.

    Each security has a face value of $200, on which interest is paid quarterly. Based upon the past four distributions, which totalled a little over $11.07, the yield is 5.43% fully franked at the current price of $203.85. And, like the PARS and WINS, the rate will ‘float’ based on the 90-day bank bill swap rate (BBSW). In essence, it’s a floating rate note paying a fully franked dividend. So all of the risks and benefits we highlighted two issues ago also apply to PERLS. We compare them with PARS and WINS in the table below.

    Quickly recapping, we like the idea of floating rate notes because we believe Australia has seen the bottom of the current interest rate cycle and so now is not the time to be locking in long-term deposits. By investing in floating rate notes, our return will rise if and when interest rates do, because the payments on these securities adjust every three months to reflect the current market rate.

    PERLS have their first ‘rollover date’ on 6 April next year. At that point, certain terms can be changed by the Commonwealth Bank. Importantly, though, the margin above BBSW is not one of those terms (it is fixed for another five years after that date). At least 50 days prior to this rollover date the bank must send PERLS holders a notice detailing the changes, if any, that will be made to the terms. Those owners who do not wish to accept the new terms have the option of converting their PERLS into ordinary Commonwealth Bank shares.

    The rate at which PERLS convert will be based on their $200 face value (not the price you pay for them if you buy them on market) and a 2.5% discount to the average market price of the ordinary shares leading up to the rollover date. We’ll keep an eye out for any changing terms and alert you if the bank tries anything that will upset our apple cart. But before we commend these securities to you, a brief warning.

    Following the successful listing of PERLS, the bank released a second offer, PERLS II. They were listed in January last year (ASX code PCBPA) and the terms look extremely unfavourable when compared to the original PERLS offer. So, with the current price of the two securities being quite similar, we urge subscribers to give PERLS II a wide berth.

    If you already own an income security or two and are not averse to adding another one, then PERLS may be just the ticket. They should also be suitable as a first foray into this area of the market. Their adjustable rate and convertibility into ordinary shares mean their share price risk is very low, which is nice given the attractive rate on offer. Even conservative investors should sleep soundly at night with up to 10% of their portfolio in these securities. BUY FOR YIELD up to $204. Because of this security’s safety and attractive yield, we’re using some of the Income Portfolio’s significant cash pile to acquire 100 PERLS—see page 3 for details.


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