House Prices in Benign Correction

In my AFR column I explain why the housing correction appears to be very benign (until the RBA raises rates); why we took profits on our AAA rated asset-backed book; why the new A- rated issue from Singaporean bank DBS looked very cheap (and has subsequently performed strongly); and why it is sad to see CBA's treasurer depart the market (click on that link to read for free or AFR subs can click here for direct access). Excerpt enclosed:

"Within my own portfolios we've recently rotated out of RBA repurchase-eligible AAA rated residential mortgage-backed securities (RMBS), which accounted for circa 10 per cent of our holdings. While these secured assets have performed strongly over the last couple of years, a record post-crisis  surge in RMBS supply coupled with the end of the housing boom convinced us to take profits. We've parked excess cash in the big banks' senior-ranking bonds, which are also RBA repurchase eligible and continue to offer annual spreads above bank bills that are 0.25 per cent higher than their 2014 levels, and more than eight times greater than where they traded in 2007. We've also selectively capitalised on cheap new issues. One that caught our attention was a new bond rated A- by Moodys from the 29 per cent government-owned Singaporean bank DBS. The Development Bank of Singapore has the same AA- credit rating as the major banks (with the benefit that it is not on "negative watch"), and a similar market cap to ANZ. It is, in fact, south-east Asia's largest bank. Like CBA, DBS is a national champion, having been founded as a public sector bank in 1968. In 1998 it acquired the Post Office Savings Bank (POSB), which was founded in 1877 by the British colonial government. Most Singaporean children grow up with a POSB savings account. After extensive due diligence, there were many things we liked about DBS. First, it is very much a "narrow" bank that focuses on core savings and loans in its home market and does not embed tail risks associated with overseas expansion aspirations or investment banking activities. Second, it has a very conservative balance sheet with a non-risk-weighted equity buffer of 7.6 per cent that is much higher than our major banks' levels, which sit around 6 per cent. Third, its loans only represent 88 per cent of its deposits compared to 130 per cent across the majors, which consequently require more wholesale borrowings that introduce greater funding risks. Fourth, its return on assets is higher than the average of the majors, which allows it to produce a similar return on equity notwithstanding its more conservative leverage. Finally, we concluded that the regulator in Singapore is just as prudent as Australia's. While the credit analysis stacked up, the key question was whether DBS's subordinated bond was cheap. If it priced in line with the major banks' subordinated bonds, it should pay a spread above bank bills of 1.4 per cent annually. If we look at DBS's US dollar subordinated bonds and swap them back into Aussie dollars, fair value is 1.34 per cent above bank bills. Based on Moody's A- credit rating, fair value is even tighter at 1.26 per cent. And, finally, on a "bottom-up" basis accounting for DBS's assets, liabilities, leverage and equity volatility, the minimum required risk premium is smaller again. All of this made the 1.58 per cent spread offered by DBS attractive. On the subject of what is cheap and dear, I've been asked several times about the new CBA Perls X hybrid issue (ASX: CBAPG). CBA's departing treasurer, Paolo Tonucci, did exactly what this column predicted last weekend, issuing at a 3.4 per cent margin above bank bills for a seven-year expected repayment date, which is a more appealing return than Westpac offered on its WBCPH security (paying a 3.2 per cent margin for a 7.5-year expected maturity). Given strong demand, CBA may be forced to close the books early on Friday afternoon, with bids scaled back. Beyond this deal, listed hybrid issuance is likely to be scant, especially if CBA taps into burgeoning over-the-counter interest in these securities with an inaugural wholesale issue to wholly or partially refinance its CBAPC maturity in December. It is sad to see Tonucci and his offsiders, Simon Maidment and Tricia Ho-Hudson, leave CBA. In my opinion they were among the most cerebral and authentic funding team in the market." Read the rest of the article here.