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 Suncorp offering with a bonus - Eureka Report article 

June 20, 2008
Suncorp offering with a bonus
By Scott Francis

PORTFOLIO POINT: Suncorp's convertible preference shares, offering an 11.8% fully franked yield, a reward that seems reasonable compensation for the risk.


One of the issues for banks - and bank investors - at the moment is the difficultly they are having in borrowing money. This has seen the banking industry turn to retail investors and offering attractive rates of interest.

And it's not just term deposits. Where a decade ago banks may have used rights issues, the flavour of the moment is hybrids, with Suncorp, Macquarie and now Westpac joining the trend.

Suddenly banks that seemed to have forgotten about retail investors are prepared to offer everything but a free set of steak knives to get their business.

Suncorp has completed a $700 million issue of "convertible preference shares" (ASX:SUNPB) that offers both an attractive rate of return with bonus franking credits thrown in for the investor! The securities listed just over a week ago. They have a "face value" (issue price) of $100 and have traded around that mark since listing.

The upside: yield

The key promise of the Suncorp convertible preference shares is an attractive fully franked income for investors. The gross income (which includes franking credits) is 11.08%. This is set as a 3.2% margin over the 90-day bank bill rate. The income is paid quarterly and is recalculated each quarter as the 90-day bank bill rate changes. When it is recalculated, it is set as the 90-day bank bill rate plus the 3.2% interest margin.

This 11.08% is made up of a 7.756% cash payment that is fully franked. To calculate the value of franking credits you multiply by the company tax rate (30%) and divide by (1 minus 0.3; ie, the company tax rate). So the calculation for the franking credits is 7.756% x 0.3 (1-0.3) = 3.324%. The gross return is 7.756 + 3.324 = 11.08%.

This income return is based on an investment of $100. If SUNPB was to trade at more than $100 the percentage return would be reduced. If it trades at below $100 then the percentage return is slightly reduced.

Yet 11.08% is an attractive income return. For a pension fund or an investor paying no tax, then that is the rate of return that they would receive after their tax refund of the franking credits. For a super fund investor (tax rate 15%) the return is 9.4% after tax. For an investor at the middle tax rate (31.5%) the after-tax return is 7.59% and for an investor on the top tax rate (46.5%) the after tax return is 5.93%.

Here is an interesting thought: 11% a year is about the return that Westpoint and Fincorp promised in their failed investment schemes. If risk and return are related, is the SUNPB offer as risky as a Westpoint of Fincorp investment? The answer is an emphatic no. The risk characteristics are completely different, although there are risks that an investor should to be aware of.

The risks to consider

In assessing the risks of the offer, the most reassuring evidence that an investor can have is the A- rating this issue has received from Standard & Poor's. It is worth noting that this is the credit rating of the specific issue. An A- issue suggests that compared to AAA or AA-rated issue it "is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions", however "the obligor's capacity to meet its financial commitment on the obligation is still strong".

To put this in perspective. there are already a number of smaller Australian banks, including Adelaide Bank and Bank of Queensland, that have ratings below A-.

That said, the issue is not "risk free". In thinking about what percentage of a portfolio should be allocated to any one investment, the issue of "institutional risk" should be considered; that is, what will the damage be in the unlikely event that Suncorp-Metway collapses?

SUNPB trades on the ASX. The value of the shares, currently around $100, can change because of a number of events. Firstly, the value should increase slightly each day as they issue comes up to making an interest payment, as interest accrues. As each quarterly interest payment is made, you would expect them to fall in value.

While you would not expect them to be nearly as volatile as Suncorp-Metway shares, they may also change because of market sentiment to Suncorp-Metway. For example, they may trade above $100 if Suncorp-Metway is seen to be performing very well and therefore the investment becomes less risky. Conversely, if Suncorp-Metway is performing poorly then the price may fall. Changes in credit rating of Suncorp-Metway, either up or down, would be likely to impact on the $100 price.

It should be noted that Suncorp-Metway deposit holders (people who hold bank accounts and term deposits) are paid before the investors in SUNPB in the (unlikely) event of Suncorp-Metway being wound up, although SUNPB holders are paid before shareholders. This is part of the reason why deposit holders see an A+ rating with the SUNPB issue being rated A-: the deposit holders have first claim on Suncorp-Metway assets, which protects their position.

Given that the quarterly income is fixed to a margin above the bank bill rate, there is a risk that the bank bill rate falls and the income will fall. If the Reserve Bank cut interest rates, then you would expect the bank bill rate to fall as well.

The conversion date is in the year 2013, where investors will receive $101.01 of Suncorp-Metway shares. Of course, investors may choose to sell on the market prior to this conversion and receive cash.

There are also situations where Suncorp-Metway can stop paying the interest on the SUNPB issue. This is unlikely, but investors should take the time to understand this aspect of the issue, which is clearly set out in its product disclosure statement.

Conclusion

The credit crunch has made it difficult for banks to access institutional money, so the long-suffering retail investor has suddenly become more important to them. An A- rated issue that offers investors a gross yield of 11.08% is well worth considering. There are risks involved, but the reward seems to be a reasonable compensation for that risk. For a number of investors SUNPB will make sense as part of their diversified fixed interest exposure. It was not so long ago that Wespoint and Fincorp were dazzling people with the promise of an 11% yield - and now a bank issue is prepared to offer investors a return slightly higher than this.
Scott Francis' articles in the Eureka Report 

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