Views at a Glance / Income Report; Action in Bank Hybrids, Portfolio Changes, Aussie Housing – will it crash? (SUN)

By Market Matters 28 March 18

Income Report; Action in Bank Hybrids, Portfolio Changes, Aussie Housing – will it crash? (SUN)

Market Matters Income Report 28th March 2018

The market has opened down again today with the ASX 200 off around -40pts at time of writing (11am) with increased volatility across the board. The US tech sector is providing the catalyst for now with the NYSE FANG index down 5.6% overnight – it’s worst drop ever. That index tracks Facebook, Google, Amazon and Netflix, or in other words, the personification of US optimism. We often use the Nasdaq as our leading indicator of global risk on / risk off, and right now the volatility we’re seeing in that index looks to be a precursor of something more sinister, the question we continue to grapple with is around timing of when a bigger move will start.

Overall – we’re now neutral the market but our preferred scenario moving forward is still a doomed attempt to break upwards towards the psychological 3000 area for the S&P 500. 

S&P 500 Chart

In terms of the MM Income Portfolio over the week, the portfolio had a poor one losing -1.10% with a clear move against the hybrid market as spreads widened, although the ASX 200 was off by -1.75% - more on this later. Since inception (5/7/17) the portfolio has gained 5.018% tracking above the market (ASX 200 is up +0.12% and the accumulation is up 3.6%) and above the portfolios benchmark (cash rate + 4%) which equates to 3.4%. As always, to view all recent activity on both MM Portfolios - click here - or navigate to the recent activity screen on the website.

Hybrids – Opportunities aplenty

We’ve seen some action in the Hybrid market over the past week with prices down and yields up. A combination of factors however the main 2 being;

1.Credit spreads have widened which is a sign that perceived risk has increased – best shown through the Australian iTraxx 5 Year CDS. 

What is the iTraxx? It’s a proxy for credit spreads in the Australian market. It’s composed of five year credit default swaps (CDS) for the 25 most liquid and highly traded investment grade Australian entities in the market. It essentially shows how ‘risky’ these institutions are perceived to be. 

Chart of iTraxx

2. Bill Shortens’ attack on cash franking credits would theoretically hit the hybrid market, although we’re now seeing a concession on this with an exemption for full and part time pensioners, which includes a pensioner with a self-managed super fund. 

That’s seen the ‘spread’ over cash for current issues to blow out to be around ~4% sealing the fate of new notes issued by Westpac (WBC) and CBA to trade below their $100 face value (issued at 3.20% & 3.40% over swap respectively).Taking a step back for a second, when investing in a share we need to predict the earnings of a company then look at all the factors that dictate the multiple that we should pay for those forecasted earnings.

With a hybrid, we’re very confident on the earnings of the instrument but as with a share, we need to think about all the factors that dictate the ‘margin’ over the risk free rate. That margin can ebb and flow (just as a P/E can ebb and flow) depending on the perception of risk. Over the last few years, the market (in terms of margin) bottomed around 2.80% over and topped out around 5.20% over. The other interesting aspect is the spread we’re seeing on the listed hybrid market over and above subordinated debt (which is unlisted) – the spread is now at record highs which suggests the listed hybrid market collectively is now cheap.

Our best picks in the Hybrid space right now; At a close of $103.40, ANZPG now offers a margin of 4.04% (6.61% yield to 6yr call date). At the shorter end, NABPC at $100.05 offers a 3.52% margin (5.54% yield to 2yr call date).

NABPC Chart

Portfolio Amendments

We need to increase cash to take up the new CBA Hybrid which we are committed to for the MM Income Portfolio, allocating 5%. The market has moved against this position and the CBA will likely open below its $100 face value. We’re also increasing our position in MXT by 2.5% through the MXT rights issue. With 4.7% in cash, we have a funding gap.

1. Reduce Suncorp (SUN) by 5%

While we remain bullish on Suncorp, this is our largest position and as volatility edges higher we are reducing such an ‘overweight bet’ by 5% to a weighting of 6%. This position is being sold for a slight profit inclusive of the dividend.

Suncorp (SUN) Chart

By reducing Suncorp by 5%, the MM Income Portfolio will now have 9.7% in cash, with 7.5% then being allocated to the CBA Hybrid (5%) & the MXT rights, leaving 2.2% in cash, which is clearly low. Perpetual (PPT) is on our SELL radar while Katmandu (KMD) is on our BUY Radar. 

Thinking outside the box for Income

At Market Matters we’re often taking the ‘non-consensus’ path and that holds true in both of our portfolios – whether it be in timing of buys when the street is negative, the timing of sells when optimism is high, the larger non-consensus calls on key asset classes or the market generally. It doesn’t always work – nothing does, however it does highlight our view that thinking differently and with a flexible mindset is the key to successful investing over time. That open mindedness has led us to look at an interesting income focussed investment fund recently. This is not a listed security, it’s closed ended with a lock up period of up to 5 years, so it’s certainly not for everyone. We can’t invest through the Market Matters Income Portfolio given it’s unlisted however that shouldn’t stop us from looking at it, and also learning some lessons from what I think are smart guys behind it.

Getting over the stigma

This is a Residential Mortgage Backed Security (RMBS) fund and those with a good eye for detail will remember that Margot Robbie discussed these type of securities in the Big-Short…simply because they were a pivotal aspect of the Global Financial Crisis. This begs the question, why would we be looking at them now?

Firstly, a residential mortgage-backed security (RMBS) is a type of asset backed security that is secured by a bunch of mortgages which are then sold to someone for a particular return. As I type away early on Tuesday morning with the DOW up +600pts and the sun rising over the harbour, I’m thinking about how best to explain this type of security.

Although I’m the only one in the office, there’s a 100 desks in front of me. Assume the 100 inhabitants of those desks have a loan against their primary residence – some loans are small relative to the equity in the ‘asset’ while others are large – they are split between interest only, principal and interest while some are also classified as ‘investor loans’. To be frank, some of the desks here are inhabited by guys/girls who I’d be happy to lend to, others not so much. By packaging these mortgages together and ‘securising’ them the bunch of mortgages generate a specific return that should be reflective of the risks involved – it’s up to the purchaser of that security to have the insight, knowhow and capability of assessing whether or not the return is under of over compensating for the risks involved.

Given these securities are still on the nose post the GFC, it seems ‘perceived risk’ over and above ‘actual risk’ is creating some opportunities. Remember, going against the flow can often yield best results over time.

The key is understanding the underlying asset (residential mortgages) and to do that we need to understand the outlook for housing, but also the trends around deliquesces / pain in downturns. Is the current concern around domestic housing warranted? How does a downturn in the housing market impact the RMBS market? What sort of decline (speed and magnitude) needs to occur for it to create an issue and probably most importantly, why does a housing market crash as opposed to correct or grind sideways for a period? Once these are answered, we can then look at the best risk adjusted return opportunities to benefit from misconceptions.

Realm is an investment house that focusses in the fixed income market, and they’re good at it. Rob Camilleri who runs the show is one of those guys that is worth listening to and right now they see opportunity in this space. I typically like funds / managers that are low on rhetoric, big on substance and importantly those with an independent view. Rob has these traits. Clearly, launching an RMBS fund is not the ‘easy’ path to go down, it’s a hard sell given the fallout from the GFC but that’s exactly why it seems there’s an opportunity,

That said, the main reason I’ve touched on this fund today is not about the actual investment opportunity – although we do like it, it’s more about the report they’ve penned titled Demystifying the big short for Australian RMBS. It’s to some degree a marketing piece for the fund, but the substance is strong. For those that own a house, invest in banks, in bank debt or want a greater understanding of how the banking system operates, this is worth a read. Importantly, it looks at what the reality rather than the media hyped perception can be – it’s well worth a read. To download the report – click here 

In terms of the fund, they are raising money now, with a target return of 4.75% over cash paying quarterly income, with the funds locked for a 4-5 year period. For more information email [email protected]

Have a great day!
James & the Market Matters Team

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