Hybrids swing in favour of investors

Suncorp CPS2 (convertible preference shares) offers 7.9 per cent a year and better protection. Past hybrid security offers shared much of the downside risks of ordinary shares without the high yields or upside potential.

With Suncorp CPS2, this unattractive risk-reward ratio is undergoing a reversal.

There are three important features that make this offer more attractive than its predecessors.

The first is a margin of 4.65 per cent above the 90-day bank bill rate. That's a significant increase from the 3.1 per cent offered on ANZ CPS3 during the early hybrid frenzy, making a total grossed-up return of 7.9 per cent at current interest rates (including franking credits). While it isn't enough to scream ''buy'', those keen on high-yield bank shares are being given plenty of food for thought.

More protection

This isn't the only factor suggesting the hybrid landscape is tilting slowly back in favour of investors.

Earlier hybrids contain a ''capital trigger event'' - CBA PERLS VI contains this and a ''non-viability trigger event''.

Each offers the possibility of suffering a forced conversion into ordinary shares at exactly the wrong time - when a bank's ordinary share price is crashing.

Suncorp CPS2 has only the latter forced trigger - one poison pill rather than two - and it contains more protection than the earlier offers. The big problem with a forced conversion is you lose your protection against the Maximum Conversion Number (MCN) (the cap on the number of shares hybrids convert into). In the earlier issues, the MCN was calculated on a ''relevant fraction'' of 50 per cent of the issue-date ordinary share price. Suncorp CPS2 uses 20 per cent.

In layman's terms, it's a significant improvement because the share price needs to fall by more than 80 per cent for losses to be incurred due to forced conversion, rather than 50 per cent.

With the CPS2 securities, losses are both less likely and lower.

Comparing Suncorp CPS2 with previous hybrid offers shouldn't be your only yardstick.

If you run the risk of being converted into ordinary shares and wearing a potentially big loss, why not make this comparison, too?

In February, Westpac ordinary shares had a forecast dividend yield of more than 11 per cent a year (grossed up). Back then, a Westpac convertible hybrid offered less than 8 per cent a year, grossed up, no upside and plenty of downside risk. How things have changed.

Offers higher margin

Right now, Suncorp ordinary shares offer a forecast dividend yield of about 8 per cent grossed up. CPS2 offers a similar dividend yield but with less downside than ordinary shares. That's a huge change in the relative merits of each proposition.

CPS2 investors won't benefit from any share-price appreciation but you are less exposed to volatility in the sharemarket and will suffer less in a distressed scenario than ordinary shareholders.

If you have been buying Suncorp's ordinary shares for yield, CPS2 offers an opportunity to take some profits without the yield sacrifice of switching to cash.

What about the risks?

First, in the unlikely event that conversion to the listed ordinary shares is unable to occur, there's a remote risk of hybrids being written off completely. Suncorp also has a lower credit rating than a big four bank, although the risk of losing the lot is more likely to reflect macroeconomic events such as a property price crash, rather than a stand-alone event making Suncorp ''non-viable''. Suncorp isn't necessarily more exposed than the big four, but it's paying a return as if it were.

Second, should the Australian Prudential Regulation Authority (APRA) decide a bank is non-viable, there would be broader ramifications. If Suncorp were to experience large insurance losses, for example, a fresh issue of ordinary-share capital may be more palatable to APRA than relying on the loss-absorbing features of CPS2, which may trigger concerns about the strength of the banking system.

Finally, don't forget the risk associated with the 1 per cent share-price discount on conversion. This won't cover normal volatility, so investors run a significant risk of a small capital loss on conversion.

Suncorp CPS2 offers a higher margin than other bank convertibles with greater potential to mitigate losses in distressed times. From a value perspective, we'd still avoid it, but this is an interesting option for those buying bank shares for their high yields. It's also a huge improvement on past hybrid offers.

The hybrid market might be swinging in favour of investors rather than issuers.

Richard Livingston is the chief executive officer at Intelligent Investor Super Advisor, super.intelligentinvestor.com.au. This article contains general investment advice only (under AFSL 282288).

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