Fixed Income

Today I argue that while Labor have given ScoMo a shot of winning the election with its shocking recent mis-steps and its bizarre tax-everything-that-moves-platform, the media coverage and political analysis has never been more biased in all likelihood because those inside the beltway fervently believe that ScoMo does not have a snowball's chance in hell of prevailing in May (click on that link to read the full column or AFR subs can click here). I go on to consider the RBA's decision to enter the political fray to canvass yet another irresponsible rate cut, and how RMBS investors are praying that the RBA bails them out because of the massive increase in RMBS risks as house prices plummet. We've updated our analysis revaluing recent RMBS bonds with the latest house price movements to end March, and the results look very ugly indeed with one widely held 2018 issue now 11.5% underwater. That is, 11.5% of all the loans in the one ostensibly AAA rated RMBS issue have negative equity. And then there are deals that have been sold to investors in the last couple of years where the share of high risk loans with LVRs over 90% were between 5% and 8%, which has now jumped to between 19.4% and 20.4% of the entire deal. And this accounts for the pay-down of loans since the bonds were sold. The bad news is that as house prices continue to fall, and mortgage arrears continue to climb, these risk metrics are certain to deteriorate. It begs the question as to whether the rating agencies, like Standard & Poor's, are asleep at the wheel. What I know for certain is that we have not touched RMBS since February 2018, which is when we largely exited the asset-class. And in 2019 RMBS has been the worst performing sector in the Aussie fixed-income market. Excerpt enclosed:

Of course, the 1,362 employees at the Reserve Bank of Australia are also frequently overwhelmed by a sense of relevance deprivation syndrome. And it appears that they too want to become political players, placing a prospective rate cut on the agenda despite a falling jobless rate that at 4.9 per cent is below the threshold the RBA considers consistent with “full employment”.

The RBA’s irresponsible rate cuts between 2011 and 2016 gave us the most highly levered housing bubble in our history, and now it wants to cauterise the cathartic market clearing by blowing the bubble back up again. According to its own internal research, a 1 percentage point reduction in the RBA’s record low 1.5 per cent cash rate would boost property prices by a stunning 28 per cent if banks passed on the full change via lower lending rates, which they are well placed to do given a dramatic compression in funding costs that this column flagged some time ago.

It makes you pity the poor 642 souls toiling away at the Australian Prudential Regulation Authority (APRA), who are responsible for supervising every bank, building society, insurance company and super fund in the country with less than half the resources of (and inferior pay to) their rich brethren at the RBA.

It was APRA that was forced to fight the extreme financial stability problems precipitated by the RBA’s easy money policies through tightening lending standards and capping credit creation, which ultimately triggered the current correction that is arguably the best thing to happen to the country in decades.

Investors in the residential mortgage-backed securities market will certainly be praying the RBA bails them out. In its latest financial stability review, the RBA revealed that a surprisingly high 2.75 per cent of all loans backing RMBS bonds were now underwater, or had negative equity wherein the value of the loan is worth more than the property securing it.

In Western Australia, almost 15 per cent of all RMBS loans are underwater. This comes at a time when the RBA estimates that home loan default rates are almost back to the highs of the global financial crisis.

When we mark to market recent RMBS issues with house price changes through to end March, we can identify one popular 2018 deal with an incredible 11.5 per cent of all its loans underwater and another three recent RMBS issues where between 6 per cent and 7 per cent of all loans have negative equity.

One final development this week was Phil Coorey’s scoop that even if Labor wins the election, the Senate is set to block its proposal to ban cash refunds on franking credits. Coorey reported that “Labor's plan to scrap cash payments for excess franking credits looks increasingly likely to fail after the Centre Alliance appropriated the Coalition's slogan to use as its own mandate in the upcoming election".

“The party, which ... is set to hold the balance of power in the Senate, has adopted the slogan Stop Labor's Retiree Tax in a bid to have a third senator ... elected," read the article.

This is a big deal because droves of retail investors have been advised to dump their franked equities and hybrids on the potentially flawed assumption Labor’s policy will be legislated.

Many of these punters have been encouraged to shift their money into much less liquid and riskier assets, including the recent spate of high yield, or junk bond, listed investment companies (LICs) that some advisers are pushing to clip enormous conflicted sales commissions worth up to 2.75 per cent of the value of the money they extract from their clients.

Litigation funders are rumoured to be licking their lips at the prospect of launching class action law suits on behalf of mums and dads who have been advised to switch into inferior investments with, ironically, lower yields and/or higher risks.

The history of LICs has been that when they perform badly, losses are severely amplified by the closed-end nature of these products, which results in them trading at large discounts to their net tangible assets. This is not a risk investors face with open-ended funds protected by the "future of financial advice" (FOFA) laws that prohibit conflicted sales commissions.

Adam Miliszewski, a principal adviser at Cervus Private Wealth, says: “I cannot tell you the number of times we’ve been recently contacted out of the blue by brokers and funds spruiking LICs holding high-yielding junk bonds. “It happened again only yesterday.”

Miliszewski says that “retail investors think they are getting a safe 5 per cent return, but simply do not understand the risks inherent in these products”.

Read the full column here.


This information does not constitute, and should not be relied on as, financial or investment advice or recommendations (expressed or implied) and it should not be used as an invitation to take up any investments or investment services. The information has been prepared by Smarter Money Investments Pty Limited (ACN 153 555 867), which is authorised representative #000414337 of Coolabah Capital Institutional Investments Pty Ltd that holds Australian Financial Services Licence No. 482238 and authorised representative #414337 of ExchangeIQ Advisory Group Pty Limited that holds Australian Financial Services Licence No. 255016. It is general information only and is not intended to provide you with financial advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. 



Comments

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Ian Ashman

Can anyone name the "recent spate of high yield, or junk bond, listed investment companies (LICs) "? What % of the total LIC market do they represent? And any chance we could put the political spruiking away? I read Livewire because it isn't infested with political garbage.

Dr Jerome Lander

Wouldn't it be nice if our central bank let the housing market continue its steady correction back towards a more reasonable valuation level, and stopped encouraging misallocation of capital, further speculation in property and housing bubbles. I wonder how much richer Australia could have been if government policy had have encouraged our capital into more productive purposes instead of property speculation. For starts, intergenerational inequity and populist movements might not be so prevalent. There is a general fallacy that central banks are omnipotent and drive the economy, but real economic growth is determined by so many other more important long term issues. And let's face it - if a mere 1.5% cash rate isn't low enough for you, what is!

Peter A

Agreed Ian. Admittedly, you wouldn't expect commentators with a background in the Finance industry to be particularly sympathetic to Labor, but the partisan rhetoric that often colours commentary about financial matters by Australian finance pundits has always struck me as unprofessional.

James Marlay

Hi Ian, recent income focused investments that Joye is likely to be referring to include Neuberger Berman, Perpetual, Metrics Credit, Gryphon Capital. The LIC and LIT market still only represents a fraction of the unlisted market. Re politics... Livewire is a platform for fund managers to share their insights. I think for the most part we do a good job of keeping the conversation focussed on investing. With a Federal Election approaching there will be inevitably a rise in articles with a political bias. There are a number of proposed policies that have implications for investors and therefor will attract (and warrant) a level of debate. But point taken - we will continue to keep Livewire focussed on investing and politics to a necessary level.

Mark White

Interesting reading after I received an email from my OTC bond broker promoting a recent "non conforming" RMBS issue paying BBSW + 2.15% (3.8%) , supposedly with the same (AAA?) rating as the Australian Government. My understanding is that the Australian Government could theoretically print A$ money to service their debts, so the ratings agency must be either extraordinarily confident in this particular RMBS issue or very well remunerated by the promoters!

Lloyd C

Difficult to see how this will not eventually affect employment levels.