Capitalise on market chaos

Christopher Joye

Coolabah Capital

Here I argue that anyone who tells you they know what's driving markets right now is lying or fooling themselves, which begets opportunity (click on that link to read the full column or AFR subs can click here). Excerpts enclosed:

November has been an unusual month in a no less exceptional year which has called into question many investment memes. Consider the data. In November Aussie shares are down 2 per cent, bringing the total return for the ASX in 2018 to negative 3 per cent (inclusive of dividends). The supposedly wonderful equities hedge – fixed-rate bonds (or "interest-rate duration") – is off 0.1 to 0.2 per cent in November. This highlights, as this column has repeatedly done, that anyone relying on a negative correlation between shares and fixed-rate bonds to protect draw-downs is delusional.

This correlation has been persistently positive in inflationary periods, such as through the 1980s, 1990s and since 2015, and was only demonstrably negative during the historical anomaly that was the global financial crisis. Yet "duration as an equities hedge" is accepted as an inviolable maxim when it is, empirically, the exception rather than the rule.

In November investment-grade floating-rate notes have been resilient, appreciating slightly, although the major banks' subordinated bonds have been smoked because of fears APRA will force the banks to issue $140 billion of these securities in the years ahead. As I explained last week, that is statistically impossible because global annual supply is less than $50 billion and there are more tractable solutions that APRA will avail itself of.

In the meantime, the majors' Tier 2 debt is suddenly offering the chunkiest credit spreads in years (40 to 50 basis points more than a month ago) after historic price falls. In just two weeks Westpac's latest five-year subordinated deal has lost 1.4 per cent of its value, while CBA's most recent 10-year Tier 2 bond has cratered 3.5 per cent, all because of APRA's misunderstood discussion paper.

Financial credit is, in fact, the only seriously cheap asset class with spreads on the major banks' senior-ranking AA- rated bonds about 10 times wider than in 2007 even though risk-weighted leverage has halved.

With house prices across the five largest capital cities down 4.5 per cent in 2018 and 5.2 per cent since their October 2017 peak (in line with our 2017 forecast for a 10 per cent peak-to-trough correction), it's been hard yakka preserving capital.

Indeed, Standard & Poor's has finally embraced our warnings of the risk of investing in residential mortgage-backed securities (RMBS) while house prices are falling. On Wednesday it declared that "the RMBS sector is now facing more elevated risk than it was 12 months ago". "Falling property prices pose a greater risk for the lower-rated tranches of less-seasoned transactions, particularly for loans underwritten at the peak of the property cycle," S&P warned, noting that "around 13 per cent of loans in Australian RMBS portfolios have a loan-to-value ratio of more than 80 per cent". We said the same thing back in August.

The surprise packet of 2018, and the best-performing asset class of those canvassed thus far, has, remarkably, been the ASX hybrid market.

Even with the shock of not one but two major bank hybrid deals launching and pricing this month, slugging investors with about $3 billion of supply, the Solactive ASX hybrids index is effectively flat in November (after income). It has appreciated 2.6 per cent in 2018 before franking credits (and is up 3.7 per cent including franking), massively outperforming equities. This is despite all the negativity surrounding Labor's franking policy, which notably only impacts the tiny minority of investors who pay little or no tax and who are therefore reliant on cash refunds...

While the market has thrown the baby out with the bathwater in relation to APRA's consultation process on having banks build more "total loss absorbing capacity" (TLAC), it's sobering to reflect on a few facts. First, APRA is eager to engage with stakeholders on how to fund what will be up to $140 billion of issuance, including whether this should be underwritten by existing "regulatory capital" instruments, or alternatives like Tier 3 securities.

Second, the Financial System Inquiry's (FSI) recommendations, which the government adopted, require APRA to develop a TLAC solution that does not materially depart from global best practice or place our banks at a competitive disadvantage in global funding markets. Trying to raise $140 billion of Tier 2 would unambiguously do this.

Third, APRA's discussion paper made it clear that it had not undertaken proper capacity or pricing analysis, explicitly assuming credit spreads remained unchanged. The 40 to 50 basis point move wider in Tier 2 bond spreads since, and the radical reduction in liquidity, is precisely why there is zero chance the $140 billion shortfall will be funded with Tier 2, even if APRA wanted to.

Finally, the FSI explicitly asked APRA to consider whether a Tier 3 bond sitting between Tier 2 and traditional senior, which has become the global best practice approach to funding TLAC, would be a cheaper option. In 2018, Tier 3 issuance of close to $350 billion has been seven times higher than Tier 2. And Tier 3 costs banks much less than Tier 2.

Whether banks use Tier 2 or Tier 3 makes no difference to APRA since both will contain bail-in clauses that allow it to swap these securities into equity if a bank is about to blow up. I expect the market will eventually figure this all out.

Read the full column here


Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs over $8 billion with a team of 26 executives focussed on generating credit alpha from mispricings across fixed-income markets. In 2019, Chris was selected as one of FE fundinfo’s Top 10 “Alpha...

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