The Motley Fool

Commonwealth Bank of Australia issues capital notes: Should you buy?

What: In a recent Australian Financial Review article Christopher Joye spelt out the risks involved with investing in bank hybrids, with specific reference to the current issue of Commonwealth Bank’s Perls VII capital notes. It is interesting to note the UK authorities have slapped a ban on selling similar products (known as CoCos) directly to retail investors.

So What: Understanding hybrid terminology is difficult at the best of times, but let’s gives it a go:

1. Although they are described in the prospectus as ‘capital notes’, Perls VII are not deposit liabilities and are effectively perpetual with no firm obligation to effect repayment. In terms of long-term exposure they are essentially in the same camp as ordinary shares and are exposed to business risk.

2. Dividends are non-cumulative; are paid out at CBA’s sole discretion, and are not liabilities of the bank.

3. As they are recognised by regulators as being “loss-absorbing” equity capital there is a measurable risk that capital will be lost completely should we experience a period similar to 1991-2 (the last significant recession). Back then, both Westpac Banking Corp (ASX: WBC) and Australia and New Zealand Banking Group (ASX: ANZ) lost around 40% of their tier-one capital – with a current gearing ratio of 25, banks are significantly more vulnerable today.

4. If CBA’s tier-one capital fell to 5.125% or less (it was 9.3% at June 30) there is an automatic conversion into ordinary shares. So the claim in the prospectus that Perls VII investors are able to rank ahead of ordinary equity holders in any winding up is ingenuous. It is likely the notes would be converted before this, heavily diluting all shareholders.

Now What: The 2.8% margin above the bank bill rate translating to a dividend of 5.45% may look ok when compared to a bank deposit. However Perls VII is not a bank deposit and is barely distinguishable from ordinary shares in terms of longer-term risk exposure. Although it can be argued that the capital notes are less exposed to capital loss than the ordinary shares this is conditional on benign conditions continuing.

Potential investors in Perls VII should exercise caution before making any commitment and would do well to check out ASIC’s rundown on income securities as a first step.

You'd better take a look at this… especially if you own bank shares!

Warning: What you read in this newly updated investment report could surprise you! Be sure to get your FREE copy of "What Every Bank Shareholder Must Know" right now. This newly updated report is yours free when you click here now.

Motley Fool contributor Peter Andersen doesn't own any of the securities mentioned

5 ASX Stocks for Building Wealth After 50

I just read that Warren Buffett, the world’s best investor, made over 99% of his massive fortune after his 50th birthday.

It just goes to show you… it’s never too late to start securing your financial future.

And Motley Fool Chief Investment Advisor Scott Phillips just released a brand-new report that reveals five of our favourite ASX stocks for building wealth after 50.

– Each company boasts strong growth prospects over the next 3 to 5 years…

– Most importantly each pays a generous dividend, fully franked.

Simply click here to find out how you can claim your FREE copy of “5 ASX Stocks for Building Wealth After 50.”

See the stocks now