PERLS lack lustre
The glossy pamphlets have been sent out and the brokers are on the phones. Those marketing efforts, combined with the featured rate of 7.4% and the magnificent Commonwealth Bank brand should all but guarantee the bank gets the $850m it is seeking through the issue of PERLS IV. We recommended the original PERLS (since redeemed), but the latest offering falls well short of the mark.
Comparison
For various reasons, PERLS IV do not offer much in the way of capital gains, though there is the potential for capital loss. But, before we explore those scenarios, let’s place that attractive-looking 7.4% under the microscope.
right next to an ad spruiking the PERLS IV offer, we found one for a term deposit at 6.4%. But there are some important differences. For a start, the dividend payments you’ll receive in relation to PERLS IV will be at a rate of approximately 5.18%. The difference between that and the advertised 7.4% will be made up in your tax return by the associated franking credits. With your trusty old term deposit, what you see is what you get – and you get all of your interest when you’d expect it.
To make the comparison easier, let’s ignore this disadvantage of the PERLS and just assume that the advertised 7.4% is comparable to the 6.4% term deposit rate (which you can top by shopping around at other reputable institutions). So what risks do you have to accept to get the additional 1% return from the PERLS?
Catalogue of risks
Firstly, in the case of the Commonwealth Bank getting into serious trouble, you’re much further up the chain for getting your money back as a deposit holder than as a PERLS IV holder. So you’re accepting a degree of ‘default risk’ in return for your extra 1% (or 100 basis points, as they say in the financial markets, a basis point being a hundredth of a percentage point).
Credit risk ready reckoner
Odds of default Additional return required (%)
1-in-1,000 0.1
1-in-500 0.2
1-in-100 1.0
1-in-50 2.0
1-in-20 5.0
You can price this risk by estimating the odds of the bank getting into serious financial trouble before the PERLS IV mature on 31 October 2012. If you think this is a 500-to-1 shot, then you’d want at least 20 basis points of extra return over the term deposit. If you think it’s a 100-to-1 shot, then you should demand an extra 100 basis points (see accompanying table).
Short of a complete blow up of the Commonwealth Bank, there’s the risk that the bank has a less serious hiccup which renders it unable to pay dividends for a period of time. PERLS IV are ‘non-cumulative’, meaning the bank doesn’t have to make good any missed payments. How much is that drawback worth? Perhaps 15 or 20 basis points, perhaps more.
Then there’s the risk that you need to sell your securities for some reason before they mature, when their price has fallen. This could happen if, for example, the yield investors require from fixed-interest investments generally, or from Commonwealth Bank securities in particular, has increased.
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