How Labor is crushing house prices

Christopher Joye

Coolabah Capital

This week I interview Tim Lawless, the head of research at Australia's largest real estate data company, CoreLogic, who says fears of a future Labor government eliminating negative gearing and doubling capital gains tax on housing (and equities) are one reason why house prices are falling as investors run for the hills.

While declining house prices fundamentally threaten the credit ratings on the subordinated tranches of residential mortgage-backed securities (RMBS), I also show a curious anomaly whereby the credit spreads on the safest, or highest-ranking, RMBS tranches have been widening while spreads on the junior tranches most at risk of downgrades have been compressing sharply. Finally, I discuss the importance of decomposing hedged US equities and bond returns from the underlying asset performance and the benefits that Aussie dollar investors have captured historically when hedging US dollars into our local currency.

Brief snippets enclosed (it is a long column):

"There's no doubt Labor's policies are adversely affecting housing demand right now as current and prospective investors fret about not being able to negatively gear and being subject to much higher capital gains tax," says CoreLogic head of research Tim Lawless...

The total value of residential property in Australia is $6.9 trillion, one-third of which is held by investors. Losses to date have wiped out about $278 billion worth of household wealth...

My central case is that prices correct by 10 to 15 per cent on a peak-to-trough basis (we're already down 4 per cent), which implies total losses of $691 billion. This is nevertheless a small payback for the fact that Aussie house prices have leapt 50 per cent since March 2012...

Last week I explained that a 10 per cent-plus fall in house prices would likely result in credit rating downgrades for the "junior" (or so-called AB, B, C and D) tranches of recently-issued residential mortgage-backed securities (RMBS), which triggered some unsurprisingly defensive denials. Most fixed-income investors, including all bank balance sheets, are long RMBS, and it is difficult, although not impossible, to get "short" the asset class (or profit from price declines). This means that almost everyone is "axed" to talk down the risks.

One investment bank did, however, highlight a notable bifurcation in the performance of the highest-ranking A tranches, which are rated AAA and will not be impacted by 10 to 15 per cent house prices falls, and the lower-ranking AB to D tranches (rated AAA to BBB), which would be affected.

The safest and most liquid A tranches are generally held by conservative institutions and typically account for 80 to 90 per cent of an RMBS deal. The riskier and less liquid AB to D tranches, which make up 10 to 20 per cent of an issue, are normally held by "sub-institutional" pundits.

The investment bank in question said that while the credit spreads on the rock-solid A tranches have increased up to 15 basis points over the past year (reducing these bonds' prices), the spreads on the dicier junior tranches have bizarrely tightened as much as 55 basis points (paradoxically increasing their prices).

So while the smart money is backing away from the sector (exemplified by a $500 million portfolio sale of A tranches during the week), unsophisticated participants are chasing the juicy yields offered on junior tranches notwithstanding the mounting risks.

Those risks include: falling house prices, which are destroying the collateral protecting these bonds as loan-to-property value ratios (LVRs) increase; rapidly rising arrears rates on the home loans that secure RMBS (contrary to what rating agencies claim); and declining pre-payment rates by borrowers, which are blowing out the expected life of these bonds....

One alternative to subordinated RMBS is high-yield credit like the ASX-listed NB Global Corporate Income Trust launched by Neuberger Berman in August. I am a fan of diversifying your cash and bond exposure into high yield, but mind the high hedging costs!

There has been a huge recent change in costs for Aussie investors who are buying US assets and hedging them back into Aussie dollars. As the chart shows, hedging a US asset into Aussie dollars used to give you a 3 to 4 per cent increase in your annual return. A 10-year US treasury bond yielding just 2.5 per cent paid an incredible 6.5 per cent return when hedged into Aussie dollars in 2011.

This tremendous tailwind generally held over the last 20 years, and super-charged returns for local investors in US equities and bonds. But the worm has turned, and you now pay to hedge US assets. Looking at historical 5-, 10- or 15-year returns from US equities and fixed-income hedged into Aussie dollars will, therefore, be highly misleading if you are thinking about future performance.

Click here to read my full AFR column or AFR subs can click 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 40 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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