Funds Focus

Glennon Capital Small Companies Ltd has recently announced the launch of a new income offer: GC1 RRCPS. Access is available through the Priority shareholder offer and a Broker Firm Offer before listing in December.

The RRCPS will pay a semi annual coupon at 5.60%pa with an initial reset date of 30th September 2024 and traded on the ASX.

Capital raised from this issue will be used to invest in securities listed on the ASX.

Disclosure: Sulieman Ravell is the author of this review and currently sits on the board of GC1 as a Non-Executive Director.
Glennon Capital
Glennon Capital Small Companies Ltd (GC1) is a Listed Investment Company that listed in 2015 and manage $37 Million (30/09/20). Funds raised will be used to invest with the existing portfolio of smaller companies (management fees of 1%pa + 20% performance fee over benchmark).

Comparables

This latest issue probably sounds familiar to regular readers, we have just reviewed the NAOS Ex-50 Opportunities Convertible Notes (NACG) and have previously written about the Clime Convertible Notes (CAMG).

Our view was that NACG offered a good risk reward profile and are likely to trade above their issue price, CAMG matures next year and whilst paying a 6.25%pa, it is now trading at a yield to maturity of 3.11%pa, illustrating the demand for good quality fixed income products in a low interest rate environment.

These products offer;

The security of a bond like investment, paying 5.6%pa and allowing investors to redeem in 4 years.
And the benefit by being able to convert to ordinary shares at a fixed price of $0.86 per share, approximately 18% above the share price on date of announcement.

Why the offer

Listed investment companies such as GC1 need to grow their market cap in order to dilute the fixed costs associated with running a Listed Investment Company.

Raising capital when the share price is at a discount, can dilute shareholders that don’t participate, making it very difficult for smaller companies with discounts to grow the company without diluting the shareholders that have supported them to date.

Convertible Preference Shares

One solution is to offer a Convertible Preference Share, effectively allowing GC1 to borrow money at 5.6%pa with the expectation that investors convert to ordinary shares should the share price return above 86c.

LICs are typically trading at larger discounts than they have historically and provide a tailwind for the conversion option.

With the market still trading approximately 10% lower than 12 months ago and GC1’s share price (72c) sitting at 14% below the cash Net Tangible Assets (NTA) (30/09/20) and the benefit of  6c in Deferred Tax Assets offsetting future tax liabilities, an 18% move in the share price over 4 years would seem readily achievable.

Pricing

In our opinion, GC1PA looks attractive on a number of measures;

4 year term deposits are below 1.00% pa and are fixed for the period with financial penalties should you wish to exit early.GC1PA allow you to access a greater 4 year return at 5.6%pa with market liquidity should you wish to exit early (subject to market pricing).
The conversion option is not dissimilar to having a (American Style) call option over ASX 300 for 4 years with a 18% hurdle. We would expect retail investors to pay close to 8% for this type of exposure, rounding the equivalent return to just under 7.5%pa (4 years).
There is almost no debt and the company holds over $43 Million dollars in assets. An estimated $48.7 Mill after this raising. GC1 pledge that they will not issue security debt senior to RRCPS without RRCPS holders approval and will not allow the Loan to Value ratio to exceed 50%.

Impact of dilution to ordinary shareholders

As we highlighted in our review of NAOS Ex-50 Convertible Notes, there are naturally concerns over dilution in the NTA when options or a convertible note are issued. There are a significant number of variables that come into play. Primarily;

the share price relative to NTA at time of exercise
the timing of exercising conversion
investment performance

The majority of RRCPS holders are unlikely to exercise if the share price remains below the exercise price of 86c, and if the share price rises relatively quickly, investors may look to exercise sooner rather than later, reducing the impact of potential dilution.

We’ve modelled some of the scenarios below. Notably, assuming 100% of RRCPS convert, the effect of dilution is relatively minor and in many cases accretive to shareholders.

Assumptions: GC1 dividends of 3c pa do not increase over the period shown, all RRCPS are converted at 4 years and excludes the impact of existing listed options
Our view
Although this is a Preference Share, the structure is relatively similar to the Clime Convertible Notes and NAOS Ex-50 Convertible Notes.

GC1 would need to lose approximately 85% in the value of their portfolio for RRCPS’ security to be impacted. Investors should take note that the portfolio invests in small and mid-cap stocks which can be more volatile.

There are a number of covenants to protect investors. Notably, events such as gearing exceeding 50%, and change of control events allow RRCPS holders to redeem.

Aside from investment risk, investors should note the size of this issue is relatively small and there is likely to be a lack of liquidity in the secondary market.

Overall, we think this provides an excellent risk reward profile and expect this to trade above its issue price. Clime Capital Notes are the closest comparable that are currently trading offering a Yield to the Maturity in 2021 of at 3.11%pa.

With only $5.7 Million available via the broker firm and priority shareholder offer to Glennon Small Companies Ltd (GC1) and Benjamin Hornigold Ltd (BHD) shareholders, we expect this offer to be heavily oversubscribed.

Notably investors looking to access this issue can still access the priority offer by purchasing GC1 shares on market to qualify before the record date.
Key features

Fixed return of 5.6%pa – Paid half yearly in arrears
Initial Reset Date in 4 years – Investors can elect to redeem 30th Sep 24
Distribution Stopper – The issuer must not distribute assets of the company if the LTV ratio exceeds 50% for more than 10 business days.
Ability to redeem in a trigger event or change of control –RRCPS holders can request redemption in the event of change of control or a trigger event such as LTV above 50%
Option to convert –GC1 RRCPS to Ordinary GC1 shares at a fixed price of $0.86 per share during the 4 year term
Semi-annual unfranked interest – Often overlooked by investors, hybrid returns are typically quoted inclusive of franking credits. Un-franked payments are more attractive as you avoid the need to wait until the end of the tax year to claim back the franking.

Note: GC1 RRCPS will be listed on the ASX and as such the price of the RRCPS will be subject to market movements. Investor’s selling on market may receive a price lower (or higher) than the issue price.

NAOS Ex-50 Opportunities Fund Ltd has recently announced the launch of a new income offer: NAC Notes. Access is available through the shareholder offer and a Wholesale Investor Broker Firm Offer before listing in November.

The Notes will pay a semi annual coupon at 5.50%pa rising to 7.50%pa and are due to mature 30th September 2027. The Notes will be traded on the ASX.

This issue will be used invest in securities listed on the ASX.
NAOS
NAOS Ex-50 Opportunities Fund is a Listed Investment Company that listed in 2014 and manage $56 Million (30/09/20) and one of three Listed Investment Companies run by NAOS. The Ex-50 fund invests in undervalued listed small and mid-cap companies with an industrial focus (management fees of 1.75%pa + 20% performance fee over benchmark).

Closest Comparables

We have previously written about the AFIC Convertible Notes (AFIG) and Clime Convertible Notes (CAMG), having used them extensively within our client portfolios.

Both issues offered investors a fixed term bond of just over 5 years at 6.25%pa, plus a conversion option should the share price rise above the strike price.

AFIG has since matured allowing investors to benefit from 6.25%pa plus a further 10% at maturity for those that elected to convert. CAMG matures next year now trading at a yield to maturity of 3.11%pa.

A bond with equity upside

Investors looking for the security of a bond like investment are able to benefit from 5.5%pa (stepping up to 6.5%pa in 5 years and 7.5%pa in 6 years, finally maturing at 7 years.
Investors further benefit by being able to convert to ordinary shares at a fixed price of $1.15 per share, approximately 16% above the share price on date of announcement.

Smaller companies such as NAOS are caught between a rock and a hard place. They typically trade a discount relative to the larger LICs, and need to grow the company in order to dilute the ongoing costs associated with being listed and eventually narrow the discount.

Since the company is currently trading at a large discount to Net Tangible Assets (NTA), any capital raised would further dilute the existing NTA. Therein lies the conundrum;

How do you grow the company when trading at a discount without diluting shareholders?

The Convertible Note allows NAOS to attract new funds, leveraging their investment returns with the benefit of increasing the shareholder base should Noteholders convert.

With NAOS’s share price sitting at 19% below Net Asset Value (NAV) and LICs typically sitting at larger than their historical discounts, we can easily anticipate a 16% move in the share price providing investors with the opportunity to convert their Notes for a premium.

In effect, investors are receiving a fixed income return (bond) with a free option over an equity portfolio.
Attractive Pricing
In our opinion, the Notes look reasonably attractive on a number of measures;

5 year term deposits are typically below 1.00% pa. Term Deposit rates are fixed for the period with financial penalties should you wish to exit early.
NAOS Convertible Notes allow you to access a greater 5 year return at 5.5%pa, rising to 7.5%pa over 7 years with market liquidity should you wish to exit early (subject to market pricing).
The conversion option is not dissimilar to having a (American Style) call option over ASX 300 for 5 years with a 16% hurdle. We would expect retail investors to pay close to 10% for this type of exposure (8% if you feel NAOS’s discount may widen), rounding the equivalent return to just under 7%pa (5 years).

There is almost no debt and the company holds over $56 Million dollars in assets. An estimated $73.5 Mill after this raising. NAOS pledge that the total indebtedness will not exceed $17.5 Million.

Impact of dilution to ordinary shareholders

There are naturally concerns over dilution in the NTA when options or a convertible note are issued. There are a significant number of variables that come into play. Primarily;

the share price relative to NTA at time of exercise
the timing of exercising conversion
investment performance

The majority of Noteholders are unlikely to exercise if the share price remains below the exercise price, and if the share price rises relatively quickly, investors may look to exercise sooner rather than later, reducing the impact of potential dilution.

We’ve modelled some of the scenarios below. Notably, assuming 100% of Notes convert, the effect of dilution is relatively minor and is arguably offset by the savings to shareholders due to proportionally lower fixed costs.

Assumptions: NAC dividends of 5.3c pa do not increase over the period shown, all Notes are converted at 5 years and excludes the impact of existing listed options (this chart was updated 29/10/20)
Our view
NAOS Convertible Notes offers an excellent risk return profile.

NAOS would need to lose approximately 75% in the value of their portfolio for Noteholders’ security to be impacted. As unlikely as this seems, investors should take note that the portfolio is relatively concentrated and invests in small and mid-cap stocks.

Aside from investment risk, we see the key risk as the likely lack of liquidity in the secondary market, albeit that we wouldn’t anticipate many sellers for this issue.

Clime Capital Notes are the closest comparable trading at 3.11%pa Yield to Maturity in 2021 and illustrate how attractive a yield of 5.5%pa is in this market.

We anticipate the Notes are likely to be redeemed at the end of year 5, with the additional two years to maturity a feature to provide flexibility in capital repayment.

With only $17.5 Million available via the broker firm and priority offer, investors who are not invested in the NAOS stable of companies will have to wait until it lists before being able to buy.

Note: NAOS Convertible Notes will be listed on the ASX and as such the price of the Note’s will be subject to market movements. Investor’s selling on market may receive a price lower (or higher) than the issue price.
Key features

Fixed return of 5.5%pa – Paid half yearly in arrears
Maturity in 7 years –Expected repayment in 5 years
Negative Covenant – The issuer must not without approval of an Ordinary Resolution, increase total debt above 40% of total assets
Option to convert –NACGA Notes to Ordinary NAC shares at a fixed price of $1.15 per share at any time during the 5 year term (conversion not applicable in years 6 and 7)
Semi-annual unfranked interest – Often overlooked by investors, hybrid returns are typically quoted inclusive of franking credits. Un-franked payments are more attractive as you avoid the need to wait until the end of the tax year to claim back the franking.

A lesson in Behavioural Economics with Teaspoons
When you think about hedging your portfolio, who would have thought Toilet Paper would have been the best hedge against a Coronavirus Black Swan event. Yet here we are in the midst of hoarding by the masses.

Supermarkets all over the country are sold out of Toilet Paper, shoppers are fighting in the aisles, bulk buying and hoarding. It seems irrational, yet any man will tell you, running out of toilet paper in a house full of ladies is akin to marital suicide. Douche does not seem to be an option (at least in my house).

But despite our rationale mind understanding that toilet paper will not run out, there is a shortage, we can see this when visiting the supermarkets, and there are repercussions to our marital bliss ☺.

If nothing else its an interesting insight into Behavioural Economics and reminded me of my time at the Savoy Hotel.
Teaspoon Economics
When I was 14, I started working as a waiter in the Savoy, one of Blackpool’s leading hotels in Northern England. The place must have been in financial difficulty because there was a shortage of teaspoons. Apparently, this had been going on for some time. As a result, it was expected that you brought in your own teaspoons for your tables.

I should add, this phenomenon did not extend to other spoons or cutlery.

As you can imagine, guests were non plus when offered a soup spoon with their coffee, or requested to share their teaspoon with the other people on their table. There became a correlation between tipping and teaspoon ownership. In an environment of pre/below minimum wage income, tipping was important.

As a result, teaspoons became a significant currency within the hotel and it led to secondary markets and other behaviours.

Waiters morphed into Scrooge at the start and end of every shift, counting in and out their teaspoons
Labour in exchange for teaspoon hire, “you help clear my tables and I’ll lend you my teaspoons”
Teaspoons as currency, “I’ll give you two teaspoons (for a table of 20), but you need to share your tips”
As soon as a table was cleared, the staff were picking out their spoons from the potwash, fearful that they would fall into “the abyss”
Teaspoons that went through the pot wash were fair game. Scavengers desperate for spoons spent disproportionate amounts of time hanging around the potwash.
Other staff would steal your spoons if you put them down. This led to waiters always carrying large pocketfuls of teaspoons.
It spilt out into our personal lives, our homes and families didn’t have spoons at home when we were on a shift.
It led to hoarding when you had enough spoons. After all, you may only need 10 teaspoons for tonight’s service, but you may need more for a banquet tomorrow night. And what if someone stole some of your teaspoons, you need backup.
You can’t carry 40+ teaspoons while running around serving guests, and this led to waiters hiding spoons in various spots around the restaurants and kitchens which in turn led to waiters spending a good deal of their shifts looking in cupboards, behind curtains, and inside teapots.
There were regular squabbles and fights broke out on occasion.

I should add, there were other hotels in the same chain in Blackpool, this phenomenon was only peculiar to the Savoy. I worked at the sister hotel, the Cliffs, based just 2 miles up the road for a few shifts and they just stared at me and my alien behaviour, counting and hoarding teaspoons.

The hotel was eventually sold to a larger group, 1st Leisure PLC. New management formally acknowledged the ridiculousness of the situation and immediately purchased thousands of teaspoons.

Within a matter of weeks, teaspoons were scarce again.

I worked there on and off for nearly 7 years while studying, I like to think it provided a sound base in behavioural economics. When I left, people were still hoarding teaspoons….

Bubbles and the corresponding behaviour are by definition irrational and continue for much longer than anyone anticipates.

Perhaps a couple of extra rolls in this week’s shopping makes sense after all?

CBA has just announced the launch of a new income offer:  CommBank PERLS 11 Capital Notes (Notes). The first round of access is through a broker firm allocation, prior to a shareholder offer and listing in December.

Note: There is no General Offer of these securities.

The Notes will pay a quarterly coupon of 3.7%-3.9% (rate determined by the bookbuild) over the 90 day bank bill swap rate (BBSW), which was 1.93% as of 2nd November, with an initial indicative rate of 5.63%-5.83%pa. The initial rate is set on date of issue. The Notes are expected to redeem on the 26th April 2024** and will be tradable on the ASX under code CBAPH.

* It is expected that the issue will be repaid at the first opportunity in April 2024 with a scheduled Exchange in 2026 (subject to mandatory conditions not being breached).

Our analysis
There has been very little new issuance over the last year. Spreads in the market have normalised with longer terms being reflected with wider spreads.

At a margin of 3.7% over the Bank Bill Swap Rate (BBSW), currently 1.93%pa, this issue sits in line with the current Big 4 bank spreads.

We view ANZ Capital Notes 4 (ANZPG) ANZ Capital Notes 5 (ANZPH), CBA PERLS 10 (CBAPG), and Westpac Capital Notes 5 (WBCPH) as the closest comparables, maturing in March 2024 – September 2025.

Non-viability Clause, Capital Trigger Event and Inability Event

Investors who are familiar with the new style hybrids we have seen over the last couple of years will be very aware of these clauses.

It is perhaps useful to understand that these clauses are as a result of APRA requiring further reassurance that in another GFC event, if required , hybrids would convert to ordinary equity, thereby reducing the bank’s debt costs and protecting deposit holders.

Now that banks have to hold a higher level of capital and a better quality loan book, it seems unlikely that any of these conditions would be breached, however, investors would do well to consider the increased disclosure and warnings within each prospectus over the last couple of years.

For those unfamiliar with the conditions, new hybrids now contain non-viability and capital trigger clauses that should the bank’s Tier 1 Capital Ratio fall below 5.125%, or APRA views the bank as non-viable without an injection of capital, the hybrids would automatically convert to ordinary shares.

We have also seen a gradual introduction of an Inability Event Clause added which states that in the event that the issuer is unable to issue further ordinary shares, ie the company has ceased trading, a Capital Trigger Event or Non-Viability Event, hybrid note holders lose their investment.

This is extremely unlikely, but investors would do well to remember the increase in yield offered carries additional risk.

Our View on CBA PERLS XI
We have maintained a cautious view over the non-viability clauses within new style hybrids, but this provides investors looking to switch equity allocation into a more stable alternative. (We do not consider hybrids a suitable alternative for fixed income/cash)

The increase in US rates has impacted the global cost of borrowing and are forecast to continue rising. Higher interest rates will likely present Investors with the dilemma of remaining in risk assets at a time that their valuations are being challenged or fleeing to safe haven assets such as bonds offering sub-standard yields. Interest rate rises are a headwind to both alternatives.

Floating rate notes such as hybrids may provide a suitable alternative for those looking to avoid the volatility of equities and the headwind of interest rate rises.

Labor attack on franking credits

We feel that the risk of a Labor Government attacking franking credits may provide some shorter term volatility in hybrid valuations as potentially dis-advantaged investors reset portfolios, but the market will likely normalise in the mid to long term.

Our view
We acknowledge that the margin of 3.7%-3.9% over BBSW is in-line with securities with similar vintages. Given the lack of issuance over 2018 and the fact that this issue is replacing an existing security CBAPC, we expect that there will be strong demand for securities.

Contact us if you would like an allocation to CBA PERLS 11 or have an existing investment in CBA PERLS 6 (CBAPC) you would like to roll into the new issue.

Key features

Indicative floating yield of 5.63-5.83%pa – based on current 90 BBSW of 1.93% and bookbuild margin range of 3.7-3.9%.
Option to redeem at year 5 with scheduled conversion at year 7 – CBA has the option to convert in April 2024 or on any subsequent dividend payment date.
Ordinary dividend restrictions – applies on the non payment of CBAPH dividends
Automatic conversion under the Capital Trigger Event and Non-Viability
Redemption highly likely in 5.5 years – although CBAPH has a 7.5 year maturity, we feel it is likely CBA will redeem/convert at the first call date in April 2024. Major incentives for redemption/conversion include the potential for reputational damage and risk of credit rating downgrade, leading to an increased cost of funding on future debt issues.

Note: CBA PERLS 11 will be listed on the ASX and as such the price of the Note’s will be subject to market movements. Investors selling on market may receive a price lower (or higher) than the issue price.

Investors looking for an allocation can contact us on 1300 559 869

We encourage you to view our online presentation An Introduction to Fixed Income