Smallest Budget Deficit Since 2013 + Why Hybrids Are Cheap

Christopher Joye

Coolabah Capital

In the AFR I review the government's latest monthly financial data, which shows that Australia's budget deficit is the smallest since 2013 and currently running much better than expected care of strong commodity prices, corporate profits, and asset price appreciation. I also present new research that prices the downside risk in bank hybrids, and suggests investors are being overcompensated for the risks they are assuming (click on that link to read for free or AFR subs can use the direct link here). Excerpt below:

"In its monthly accounts, the Department of Finance reports that the government's underlying cash balance for the 2017 financial year was a $30.4 billion deficit, $8 billion less than anticipated based on this year's revised budget profile. This was driven by superior tax receipts, which are expanding at the fastest year-on-year pace since 2013. "The upside surprise in the budget reflects excellent business conditions, higher commodity prices, solid employment growth, ongoing asset price appreciation and, importantly, spending restraint," says CommSec's Craig James. In May, total public expenses were $2.3 billion lower than projected under the revised budget profile. More significantly, the government's revenue growth has exceeded the increase in its cost base for 25 consecutive months. Whereas the government's budget assumes iron ore trades at US$66 per tonne for the remainder of 2017 (Standard & Poor's forecast was lower at US$60), spot prices are much higher at US$78. On a rolling 12-month basis to May 2017, the budget's $29 billion fiscal deficit was the skinniest since September 2013, which is a coup for Treasurer Scott Morrison. The nation's external balance, as proxied by the current account deficit, has likewise smoked pessimistic rating agency expectations. The March reading came in at just 0.7 per cent of GDP compared to S&P's base case that it would remain above 3 per cent of GDP when it put Australia's prized AAA rating on negative watch in 2016...Notwithstanding the sanguine conditions, the search for cheap assets is challenging when most investments are dear. With this in mind, Melbourne Business School's Dr Sam Wylie has some alternative perspectives. Wylie argues that "bank hybrids' reward-to-risk ratio, and their defensive qualities, are so attractive that investors should consider [them] despite their complexity". He is right that hybrids can be defensive vis-à-vis ordinary shares. Over the last 12 months the hybrid Wylie focused on, CBA'S Perls VII (ASX: CBAPD), has displayed one-third the volatility of CBA's shares. Wylie developed a model that conceives of a hybrid as a "combination of low-risk bonds plus embedded put options". Doing so allows him to conclude that "CBAPD investors are getting a yield of about 1.30 per cent annually more than is justified by the risk they are taking". I asked my quant research team to enhance this method applying more conservative assumptions...Whereas Wylie assumes hybrid investors hold a quasi-risk-free bond plus the option position, we submit that the equity volatility that is the main driver of capital losses through the option position is not the only potential source of, or proxy for, risk given the nebulous nature of the hybrid's non-viability clause. It is, for example, technically possible, albeit unlikely, for the non-viability clause to be exercised in situations where equity has not fallen through the option's exercise price. We control for this additional risk by assuming that the bond is a junior subordinated Basel 2 security with no non-viability clause or equity capital ratio trigger. Like Wylie, we value the required risk premium on the bond and then price the American put option using a binomial model. For CBAPD the parameters of the latter include a current share price of $75, an exercise price of $15.90, and a time to expiry of 7.5 years. We also account for CBA's fully franked dividend yield, and use the implied volatility associated with long-dated and deeply out-of-the-money put options. This suggests a fair value price for CBAPD of $101.39, which while below Wylie's estimate of $103.55, is way above the current $96.74 price. That is, CBAPD looks cheap. We repeat this exercise for all major bank hybrids on the ASX and find that current market spreads are universally above those required by this fair value framework. Put differently, investors are being over-compensated for selling the put option to CBA. This reconciles with our bottom-up valuation work where we explicitly model the likelihood of default, recovery rates, and expected loss." Read full article at AFR here.


Christopher Joye
Portfolio Manager & Chief Investment Officer
Coolabah Capital

Chris co-founded Coolabah in 2011, which today runs $7 billion with a team of 33 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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