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CBA Perls VII not the risk-free bet they appear

The past few years have been an easy ride for share market investors.

Double-digit capital gains coupled with growing dividends have been the order of the day. Investors in the big banks, especially, have never had it so good.

In case you’ve forgotten, it’s highly unusual for blue chip, large-cap stocks like Commonwealth Bank of Australia (ASX: CBA) and Westpac Banking Corp (ASX: WBC) to gain 50% in the last two years, the fully franked dividends on top.

Low interest rates, coupled with the favourable taxation treatment of dividends, and the rise and rise in self managed super funds (SMSF) has done the trick. Cheer, cheer your rising portfolio.

That’s the good news.

The bad news is the banks are no longer no-brainer investments.

Many investors are blind to the downside risks, including the very real possibility of house prices falling.

The AFR recently reported one of Australia’s top economists, Jeremy Lawson, as saying…

“…the housing market is 20 to 30 per cent overvalued and has left Australia vulnerable to international shocks.”

His biggest fear to for the economy is a sharp slow-down in Chinese growth.

Now, I don’t mean to add to the warning bells, but when bank stocks make up 50% or more of some retirees portfolios, all I can say is — be prepared.

I prepare through diversification, both across sectors and stocks.

I also always run a healthy cash balance. It lowers my risk, increases by ability to sleep well at night, and allows me opportunities to buy quality shares on the cheap when the next share market correction comes along.

That’s not to say a correction is imminent, even though we’re overdue one. And it’s not to say your bank stocks are about to take a 30% haircut. It is to say, be aware of the inherent risks of a highly concentrated portfolio.

When it comes to China, there are some canaries in the coal mine.

A falling iron ore price, for one.

The AFR reports, the chief China economist at UBS, Wang Tao as saying…

“All told, over the last decade… there have been around 49 million surplus apartments built in China. The ongoing property downturn is not just another cycle. It’s a structural imbalance.”

The same article quotes Gan Li, a professor at Texas A&M University, as estimating there are 48 million empty properties across China, equating to a vacancy rate of 22.4 per cent.

All of which means tread very carefully before putting money into the Commonwealth Bank of Australia’s latest hybrid security, known as Perls VII.

With term deposits riding at 3%, I get that Australian investors are desperate for yield, and by comparison, a 5.5% yield on Perls VII seems attractive.

But, unlike term deposits, Perls VII are not risk-free. As Christopher Joye says in the AFR

“I’m not a buyer of Perls VII at current pricing because I’m unwilling to accept equity risks for returns that are way below ordinary CBA shares. If I wanted dividends north of 5 per cent annually, I would buy CBA’s equity and get the (grossed up) 7 per cent-plus yield.”

All that’s presuming you want to increase your exposure to Commonwealth Bank.

Twenty three recession-free years bring a certain level of confidence to Australian bank investors. And rightly so.

But just like a share market correction is a case of when, not if, so is a recession. It’s then you’ll be thankful for your diversified portfolio, and your healthy cash balance.

Be prepared.

A better bet than Perls VII

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Bruce Jackson has an interest in Commonwealth Bank of Australia shares.

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