Report Created on 20 February 2017 Issuer Name Commonwealth Bank of Australia Security Name PERLS IX Key Characteristics Product Type Capital Note Issue Size* [$750,000,000.00] Par Value $100.00 Fixed/Floating Floating Last Price $100.00 Accrued $0.00 Capital Price $100.00 Running Yield** [5.680-5.880%] Security Recommendation Subscribe Security Risk Upper Medium Payment Frequency Current Distribution** Issue Margin / Coupon*** Franking Credits Incl. Quarterly [5.680-5.880%] [3.900-4.100%] Yes Yield to Maturity*** [6.515-6.715%] Trading Margin - Optional Call Date [31 March 2022] Legal Final Maturity ASX Listed Yes (Prospective ASX Code: CBAPF) Next Ex-Date [29 May 2017] Issuer Outlook Convertible Yes Next Payment Date [15 June 2017] Improving Stable Deteriorating GICS Sector Banks Next Cash Distribution**** $0.83 *Issue size is subject to change but expected to be $750 million. **Based on prospective issue margin below plus 90-Day BBSW of ~1.780%. ***Based on prospective issue margin in the range of [3.900-4.100%] & interpolated swap rate to the call of 2.615%. ****Actual cash amount based on $100 face value. Summary On the 20th of February 2017, the Commonwealth Bank of Australia (CBA) announced a new issue namely PERLS IX (Prospective ASX Code: CBAPF). The purpose of this transaction is to provide Regulatory Capital for the group but more specifically, it will be treated as additional Tier 1 capital. The indicative size of the offer is [$750 million] but CBA retain the ability to change the issue size. The notes will be offered to eligible holders of Colonial Subordinated Notes (ASX: CNGHA) (priority securityholder offer) and through the broker firm offer. These securities are structured as perpetual, unsecured, convertible, transferable, redeemable and subordinated notes. Distributions are discretionary, fully franked, floating rate, non-cumulative and subject to payment conditions. Interest payments will be paid on a quarterly basis based on a calculation equal to 90-Day BBSW plus an interest margin in the range of [3.90-4.10%] set through bookbuild, multiplied by (1 Current Company Tax Rate). If a distribution is not paid, the issuer is prevented from paying any distributions to ordinary shareholders until a full distribution is paid on a subsequent payment date. This security has no fixed maturity date but is scheduled for mandatory exchange into CBA ordinary shares on the 31st of March 2024 (or later) subject to conversion conditions being satisfied. At the issuer s discretion, and subject to approval by APRA, the notes may be redeemed or resold on the 31st of March 2022. As this security meets the new capital instrument eligibility criteria under Basel III it also contains the loss absorbing terms and conditions known in the documentation as Capital and Non-Viability Trigger Events. Upon the occurrence of these events this security will be converted into ordinary shares without the protection of conversion conditions. For the purposes of the conversion calculation, the maximum conversion number will be set at the issue date. If conversion cannot occur for any reason the notes will be written off and all holders rights terminated. Figure 1: Capital Structure 1 Figure 2: Relative Value 2 0.1% Deferred Tax Liability 62.4% Deposits 1.3% 0.2% 2.6% 14.5% 9.8% 1.1% 1.8% Life Insurance Policy Liabilities Unitholder Liability Covered Bonds Senior Unsecured Other liabilities Tier 2 Regulated Capital Tier 1 Regulated Capital Common Equity 20 February 2017 Page 1
Security Recommendation - Subscribe as at 20 February 2017 BondAdviser currently recommends this security as Subscribe. This is the fourth listed security offered by CBA which qualifies as Basel III compliant Tier 1 Capital (the last being PERLS VIII which was offered in March 2016). From a credit risk perspective (that is uncertainty surrounding the stability of the credit profile) CBA's strong earnings capacity, capital buffers and risk management systems all mitigate downside risks for capital investors. Any significant change to the capital price is more likely to be be driven by market supply imbalances and/or larger prudential and economic changes such as potential changes to the regulatory framework as advised in the financial system inquiry. In our opinion the changing regulatory landscape is a credit positive for all Tier 1 instruments. Potential increase in capital requirements, lending constraints and higher risk weights are a positive outcome for holders of debt and hybrid instruments issued by banks. While these changes may not be welcomed by shareholders they should reduce inherent credit risks if deployed in an orderly manner. From a valuation perspective, there are a number of comparable securities in our universe which give us confidence in our valuation and our analysis suggests this security is being offered to investors at a margin which is fair and commensurate with its risk. On this basis, we recommend investors Subscribe. Our valuation assumptions for this security are based on the security being redeemed (in full) on the first optional call date (31 March 2022 or 5 years) and all interest payments being made in a timely manner. If this security is not called on this date (extension risk) the price of the security will drop significantly. Risk of events such as non-viability or a capital event triggering conversion (or write off) are common across new style Tier 1 securities, but we consider the probability of such events for CBA to be remote in the current environment. Investors should note these terms make the return profile asymmetric (unlimited downside but limited upside) and in all likelihood its performance will have a higher correlation to equities than a traditional fixed income instrument during a period of stress. The most likely scenario for a breach of these triggers would be either (or a combination of) a significant and sharp deterioration in the asset quality of residential mortgages (which would affect all banks) or a failure of risk management within an institution that would lead to significant losses. If these events are triggered they are likely to cause a significant capital loss to the investor. All of these factors have been considered in our recommendation. Positive / Negative Risk Factors What factors would change the Recommendation UP The domestic regulator (APRA) continues to implement strict controls over domestic banks. The Liquidity Coverage Ratio (minimum 100%) became enforceable on the 1st of January 2015 and the Net Stable Funding ratio (minimum 100%) has an implementation date of the 1st of January 2018. These ratios will significantly improve the transparency of risks, in addition to capital, to investors; The recommendations of the financial services inquiry are becoming a reality. APRA announced a change to capital adequacy requirements in the form of increasing the average risk weights for residential mortgages from ~16% to at least 25%. Although this was at the low end of the recommendation (25-30%) it should be viewed as an interim change while APRA awaits the Basel Committee on Banking Supervision (BCBS) review of risk weighted assets in general. As of 1 July 2016 the major banks have complied with this rule. This decision was a positive for all holders of bank capital instruments as it increases the amount of core equity capital required to be held, thereby reducing the common equity leverage. The increase in nominal capital held increases the buffer against unexpected losses in mortgage portfolios and in APRAs mind improves financial stability of the system. These changes (with more to come) will improve the standalone credit profile of the banks and their individual securities; APRA recently announced (after the January 2017 delay) that it will no longer wait for the BCBS to finalise its work on the revised bank capital regime and intends to define its unquestionably strong capital levels in the coming months. We believe this will result in a higher minimum capital requirement from the banks; In July 2016 APRA provided an update to the study comparing capital levels of the major banks on an internationally comparable capital level basis. The findings of this study were simply that Australian banks remained strongly capitalized and were on track to be in the top quartile of banks globally when measured by capital ratio. Driven by strong organic capital generation and prudent management, CBA s internationally comparable Common Equity Tier 1 Ratio was 15.4% as at 31 December 2016; The Commonwealth Bank has a significant loss absorption cushion through earnings, capital and provisioning which are the primary defences of the bank to loan and security impairments. This is likely to increase through the introduction of the above capital adequacy requirements. What factors would change the Recommendation DOWN Distributions on this security are discretionary and subject to payment conditions. The primary risk here is that the minimum common equity ratio (CET1) (inclusive of D-SIB and capital conservation buffers) required by APRA is 8.0% could possibly increase further. This means that if CBA is unable to restore the CET1 ratio to a level above the minimum requirements, distribution payments may not be able to be made. This is to ensure CBA is complying with APRA s current capital adequacy requirements. This is partially mitigated by internal capital targets and distribution and capital restrictions; This security includes the Capital and Non-Viability Event trigger terminology. If breached, investors are at risk of substantial capital losses. A significant and sharp deterioration in the asset quality of residential mortgages (which would affect all banks) or a failure of risk management within an institution could adversely affect the loss absorption cushion of the group and result in an event whereby conversion (or write-down) is triggered. This is an unlikely but possible event; 20 February 2017 Page 2
Downwards pressure on credit rating. Rising property prices and increased household debt to GDP has led to S&P warning Australian banks that any further deterioration would lead to a potential downgrade of their standalone credit rating. On the 8th of August 2016 APRA announced the finalisation of the non-capital components of the supervision of conglomerate groups. These regulations are expected to provide additional tailwinds for CBA due to the size of Colonial Holding Company Limited. CBA has acknowledged that capital benefits arising from the debt issued by Colonial will be phased out but this might only be part of the overall requirement. CBA discuss the scope of application upon Level 3 group capital in the June 2016 Pillar 3 report, saying they are adequately capitalised. APRA are now in the process of formally determining the Level 3 Heads and members of each of the Level 3 groups between now and 1 July 2017 when these requirements take effect. Issuer Outlook - Stable as at 20 February 2017 Earnings CBA reported statutory net profit of $4.89 billion up 6% (cash earnings of $4.90 billion, up 2%) for the half year 2017 (1H17). Operating income grew 3% and at a faster rate than expenses (1%), after adjusting for one-off software amortisation, leading to a marginal (0.70%) improvement in the underlying cost-to-income ratio to 41.5%. The groups margin was impacted by higher funding costs with Net Interest Margin (NIM) down 0.04% to 2.11%. This impact was softened by other banking income, which increased 24% as a result of stronger fees and commissions as well as the one-off impact of the profitable sale of the Visa investment ($397 million). This result was driven by the strong performance of Retail Banking (50% of the group NPAT), which benefited from customer satisfaction and volume growth and reported statutory NPAT growth of 9%. Net home lending growth was 7.7% (above system growth of 6.7%) in 1H17. This was offset by soft performance of the Wealth and Insurance divisions (NPAT -35%) in line with the weak sector performance. Gross investment spend reduced 12% to $6 billion over 1H17 (up 1.6%) largely due to completion of key branch and ATM transformation projects. However, productivity and growth (53% of spend) remain a key focus of the investment. CBA remains well positioned to reap gains from productivity and technological advancement to offset these additional costs and remain ahead of their peers in this regard. The robust earnings performance and conservative approach to housing loan growth support the credit profile of the bank and we believe that it remains well positioned in terms of market strategy. Capital Over the half, the common equity tier 1 (CET1) ratio fell 0.6% from 10.2% to 9.6% primarily driven by higher risk weighting for Australian mortgages and final dividend. This decrease was partially offset by capital generated from earnings. On an internationally comparable basis the CBA Basel III CET1 ratio is 15.4% which places it in top quartile of amongst international peer banks as of APRA s update on 4 July 2016. Management indicating a further correction of ~0.20% to the capital ratios as an impact of the regulatory requirements, our analysis suggests that the CET1 ratio could fall to is 9.4%. This would imply capital buffers just over 1.4% of risk weighted assets (RWA) to absorb any asset and/or market deterioration before interest payments cease on additional Tier 1 instruments. It is arguable that this buffer should be higher and dividend payout ratios should be lower but this buffer us more than sufficient to cover any unforeseen losses in the near term. CBA maintained their dividend payout ratio at 69.9% (1H16 was 69.8%). However, CBA announced the intention to issue a Tier 1 Capital instrument subject to market response. This will help strengthen the group s capital position in addition to solid organic capital generated through earnings. Asset Quality The asset quality of CBA remains strong although loan impairment expenses were up 6% to $599 million in 1H17. The was primarily driven by increased provisioning levels in Bankwest and Retail Banking Services with mining exposures in Western Australia resulting in higher home loan and personal loan losses. However, the impairment ratio stayed flat at 0.17% of gross loans and advances. In line with APRA s 10% growth cap on investor lending, the CBA also announced an increase in standard variable investor home loans and cap on third-party transactions, reaffirming that it will not chase loan growth at the expense of quality. Total provisions for impaired loans increased by 3% over the year to $3.82 billion. This was due to individually assessed provisions increasing by $98 million (increase in Consumer $63 million and Commercial $52 million, offset by a decrease in Bankwest of $7 million) over 1H17. Overall, there was no economic overlay indicating prudent provisioning and strong asset quality for the bank. Funding and Liquidity Liquidity and funding conditions facing the banking sector improved over the period. The bank benefited from these conditions and strengthened its liquidity and funding over the period. Liquid asset balances increased to offset the $10 million reduction in Committed Liquidity Facility (CLF) effective 1 January 2017. CBA reported a Liquidity Coverage Ratio (LCR) of 135% as at 31 December 2016 (up by 15%) based on qualifying liquid assets of $154.74 billion (up 11%). But with the rollout of the reduction in CLF, we expect this to normalise to previous levels (~123%) in the short -term. The Net Stable Funding Ratio (NSFR) stood at 105% (above the 100% APRA requirement effective 1st January 2018). This suggests the group is in a solid position to manage any short-term funding shocks. From a funding perspective, customer deposits increased by 8% to $541 billion, representing 66% of total funding. During the period, $43 billion of term funding was issued at a lower cost and for a longer term, driving the WAM of LT wholesale funding up 0.3 years to 4.2 years. Outlook 20 February 2017 Page 3
Operating conditions for CBA, and banks in general, are expected to remain challenging over the next 12 months. Over recent months we have seen all four major banks respond to the regulators demands to tighten their lending criteria and demonstrate that the actual assessment process for new residential mortgages is beyond reproach for owner occupiers and investors alike. The combined requirement for lower LTV caps, higher average risk weights and the 10% growth cap on investor lending will constrain loan growth. At the same time, APRA is likely to define its unquestionably strong capital for banks, which in our opinion will lead to an increase in minimum capital requirements. CBA s large market share (29.01% based upon APRA s December monthly banking statistics) in the residential mortgage market means it is more sensitive to macroeconomic changes (i.e. unemployment) than the ANZ and NAB and we will continue to carefully monitor arrears rates on unsecured lending for signs of deterioration. However, given the low interest rate environment and quality of the loan book we do not expect a significant deterioration in asset quality. We also expect CBA to continue to focus on the regulatory changes that are still within the consultation stages. Overall, in the context of a challenging macroeconomic environment, CBA delivered a robust performance and we are confident that the management s strategic direction will continue strengthen its credit profile. 20 February 2017 Page 4
Figure 3: Credit Curve (Comparable Securities) 2 Figure 4: Historical Trading Margins of Comparable Securities 1 The balance sheet structure diagram represents a measure of liabilities and captial in order of seniority of the overall cash balance sheet. 2 Pricing as at close of business 17 February 2017 Source: BondAdviser 20 February 2017 Page 5
Hybrid Commentary Over the last decade, the Major Bank Additional Tier 1 Hybrid market has grown substantially in line with the regulatory framework that governs the Australian banking system. Figure 5. Major Bank AT1 Hybrid Issuance Issuance Size $10.0 bn $9.0 bn $8.0 bn $9.2 bn NABPB $7.0 bn $6.0 bn $5.0 bn $4.0 bn $3.0 bn $2.0 bn $1.0 bn $0.0 bn WBCPE $5.9 bn NABPA WBCPG $3.9 bn $3.6 bn $3.2 bn WBCPB NABPD CBAPD $2.5 bn WBCPF CBAPB WBCPC $1.9 bn $2.1 bn $1.5 bn CBAPE WBCPD WCTPA WBCPA $1.3 bn NABPC ANZPB CBAPC ANZPA ANZPC ANZPE PCAPA CBAPA ANZPD ANZPF ANZPG 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Source: BondAdviser Despite heightened issuance by the four major banks in 2016 (~$6 billion), security trading margins have compressed significantly from well-received demand for retail and institutional investors alike. Figure 6 shows the average trading margin for Tier 1 hybrids issued by Australian banks over the past decade. Post the GFC, the trading margin has remained range bound between 2.5% and 4.5% and given current valuations, appears to be at fair value. Figure 6. Average Major Bank Tier 1 Hybrid Trading Margin since 2006 10.00% 9.00% 8.00% 7.00% 6.00% 5.00% 4.00% 3.00% 2.00% 1.00% Average Major Bank AT1 Hybrid Trading Margin Post GFC Range 0.00% 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: BondAdviser as at 17 th of February 2017 20 February 2017 Page 6
Trading Margin Research Report Credit curves across the capital structure have flattened over the course of 2016 resulting in limited term premium associated with longer-term instruments. However, we judge the current margin in the range of ~ [3.90-4.10%] for CommBank PERLS IX Capital notes as being commensurate both on a relative value basis and consistent in relation to CBA s own credit curve across the capital structure. Figure 7. Major Bank Credit Curves by Capital Structure Position 5.00% 4.00% CBAPF, 5 yrs, [3.90-4.10%] WBCPG, 4.8 yrs, 3.85% NABPD, 5.4 yrs, 3.98% ANZPD, 4.5 yrs, 3.91% 3.00% CBAPE, 4.7 yrs, 3.67% ANZPE, 5.1 yrs, 3.78% 2.00% 1.00% 0.00% 0 1 2 3 4 5 6 7 Term (Years) Senior FRN Tier 1 Tier 2 CBAPF Indicated Margin Range Source: BondAdviser as at 17 th of February 2017 With the RBA reducing the official cash rate twice last year to the current 1.50%, the reference 90-day bank bill swap rate (BBSW) is at ~[1.77%]. With the PERLS IX Capital Notes book-build ~[3.90-4.10%] & interpolated swap rate to the call of [2.61%], this would imply an initial grossed up Yield to Call (YTC) in the range of of [6.51-6.71%]. Figure 8 shows the grossed-up yield to call (YTC) of CBAPF compared against existing CBA Tier 1 hybrids. Figure 8. Historical YTC for Comparable Tier 1 Hybrids 9.50% Grossed Up YTC 8.50% 7.50% CBAPF [6.51%-6.71%] 6.50% 5.50% 4.50% 3.50% 2.50% CBAPC CBAPD CBAPE Source: BondAdviser, as at 17 th February 2017 20 February 2017 Page 7
Commonwealth Bank of Australia: Financial Summary Commonwealth Bank of Australia: Financial Summary Recommendation Summary Subscribe 20 February 2017 Profit and loss 2016 2015 2014 2013 Asset Quality & Provisions 2016 2015 2014 2013 Net Interest Income ($m) 16,935.0 15,765.0 15,091.0 13,944.0 Fee Income ($m) 3,225.0 3,276.0 3,213.0 3,043.0 Trading Income ($m) 1,087.0 1,039.0 922.0 863.0 Wealth Management ($m) 2,952.0 2,940.0 2,987.0 2,721.0 Other Banking Income ($m) 548.0 558.0 188.0 250.0 Total Revenue ($m) 24,747.0 23,578.0 22,401.0 20,821.0 Total Expenses ($m) -10,429.0-9,993.0-9,499.0-9,010.0 Pre-Provision Profit ($m) 14,318.0 13,585.0 12,902.0 11,811.0 Provisioning Expense ($m) -1,256.0-988.0-953.0-1,082.0 Taxation ($m) -3,592.0-3,439.0-3,250.0-2,953.0 Minority Interest and Pref -20.0-21.0-19.0-16.0 Group Cash Earnings ($m) 9,450.0 9,137.0 8,680.0 7,760.0 Adjustments ($m) -223.0-74.0-49.0-142.0 Group Statutory Earnings ($m) 9,227.0 9,063.0 8,631.0 7,618.0 Annual Provision Charge/Gross Individually Assessed (%) 0.17 0.16 0.17 0.19 Collective (%) 0.01 0.00-0.01 0.00 Total Charge (%) 0.18 0.15 0.16 0.19 Gross Non-Accruals ($m) 3116.00 2855.00 3367.00 4330.00 Loans Past 90 Days Due ($m) 1899.00 1753.00 1620.00 1760.00 Annualised Provisional Charge/Risk Individually Assessed (%) 0.30 0.27 0.31 0.32 Collective (%) 0.01 0.00-0.02 0.01 Total Charge (%) 0.32 0.27 0.28 0.33 Provisioning Coverage Specific Provisions/Impaired Assets 30.80 31.10 33.50 37.60 Collective Provision/Credit Risk 0.86 0.87 0.95 1.01 Total Provisions to Gross Loans and 0.54 0.55 0.63 1.36 Capital Adequecy 2016 2015 2014 2013 Funding & Liquidity 2016 2015 2014 2013 Fundamental Tier 1 (%) 15.18 13.87 14.14 13.39 Deductions (%) -4.62-4.81-4.84-5.18 Core Equity Tier 1 (%) 10.56 9.06 9.30 8.21 Residual Tier 1 Capital (%) 1.80 2.10 1.83 2.04 Tier 1 Capital (%) 12.35 11.16 11.14 10.25 Tier 2 (%) 2.01 1.54 0.87 0.94 Total Risk Weighted Capital 14.36 12.70 12.01 11.19 Credit ($m) 344030.00 319174.00 289138.00 279674.00 Market ($m) 9439.00 6335.00 5284.00 5151.00 Operational ($m) 33750.00 32363.00 28531.00 28044.00 IRRBB ($m) 7448.00 10847.00 14762.00 16289.00 Total Risk Weighted Assets 394667.00 368719.00 337715.00 329158.00 Dividend Payout Ratio (%) 76.10 74.70 74.70 75.60 Deposit (excluding CD's) Growth (%) 6.20 9.30 9.10 63.60 Deposits (excluding CD's) as % of GLAA 73.70 75.80 73.60 91.30 Liquid Assets ($m) 134.0 131.9 139.4 136.7 Balance Sheet 2016 2015 2014 2013 Loans ($m) 671,608.0 624,324.0 585,908.0 550,010.0 Liquids ($m) 145,849.0 130,548.0 119,463.0 103,627.0 Goodwill ($m) 10,384.0 9,970.0 9,762.0 10,423.0 Trading Assets ($m) 34,067.0 26,424.0 21,459.0 19,617.0 Other ($m) 54,462.0 52,114.0 44,022.0 44,463.0 Total Assets ($m) 916,370.0 843,380.0 780,644.0 728,140.0 Deposits ($m) 540,813.0 510,104.0 473,186.0 442,949.0 Wholesale Debt ($m) 219,802.0 204,055.0 188,547.0 166,608.0 Other ($m) 97,890.0 78,050.0 71,604.0 75,129.0 Total Liabilties ($m) 858,505.0 792,209.0 733,337.0 684,686.0 Equity ($m) 57,865.0 51,171.0 47,307.0 43,454.0 Source: Company data, BondAdviser estimates. 20 February 2017 Page 8
Research Methodology Every research report prepared by BondAdviser includes a clear recommendation - Buy, Hold or Sell - on the security. This recommendation framework is designed to help investors navigate different investment opportunities by identifying the market price, yield, term to maturity, liquidity, volatility and risk. The guide below may help you understand our research opinions. For further information on our research approach, you can refer to our RG79 statement by clicking here. Research Opinions key Buy - Over the next 12 months, the analyst expects the security to outperform the current yield due to credit spread tightening or favourable movements in the underlying yield curve. Hold - Over the next 12 months, the analyst expects the security to provide stable returns broadly inline with the current yield but with little credit spread tightening. Sell - Over the next 12 months, the analyst expects the security to underperform the current yield due to credit spread widening or adverse movements in the underlying yield curve. Suspended - The recommendation has been suspended temporarily due to the disclosure of new information or market events that may have a significant impact on our recommendation. This also includes situations where we have been given non-public information and we need to temporarily suspend our coverage in order to comply with applicable regulations and/or internal policies. Not Rated - A security that has not been assigned a formal recommendation. Analyst Nicholas Yaxley Credit Research nicholas.yaxley@bondadviser.com.au About BondAdviser BondAdviser is an independent research company that specialises in bonds and fixed income securities. We provide investors, advisers, brokers and institutions with research, data, education and tools to help them invest intelligently. Our service is delivered online via an easy-to-use portal. BondAdviser has the broadest coverage of retail-accessible ASX-listed and over-the-counter securities, including primary and secondary issues. Our expert credit team draws on its extensive experience and robust research process to deliver unbiased insight backed by detailed analysis. At BondAdviser, our goal is to lift the lid on the fixed income market so that more investors have the opportunity to invest in the asset class directly. Learn more To learn more about the fixed income market visit our website Important Information The web application, the Content and the Reports are not intended to provide financial product advice and must not be relied upon as such. The Content and the Reports are not and shall not be construed as financial product advice. The statements and/or recommendations on this web application, the Content and/or the Reports are our opinions only. 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