Record high property prices and cheap bonds

by | Aug 29, 2016 | property

This article was first published by Christopher Joye in afr.com.au on Aug 26 2016 | Image: Boom-time auction clearance rates exceed 80 per cent on the east coast

Christopher Pearce


Australia is about to get a new house price record surpassing James Packer’s $70 million. Can’t say when, but it’s coming. Yet if you listened to the Reserve Bank of Australia rationalising its August rate cut, you would have been led to believe that “the most recent data suggest housing prices declined in most capital cities in July”.


That’s nonsense: the best available dwelling price data (CoreLogic’s hedonic index, which was designed in consultation with the RBA) reports that home values rose 0.8 per cent in July across the five largest capital cities. They’ve risen another 0.8 per cent over the first 25 days of August.


Since June 30, national dwelling values have inflated at an 11 per cent annualised pace, which gels with boom-time auction clearance rates exceeding 80 per cent on the east coast.


The RBA loves to dismiss this as a Sydney-Melbourne phenomenon – but those two cities represent almost half of Australia’s entire metro population. It would be like ignoring the resources boom because it was generated by only 15 per cent of the economy.



Dwelling prices have been rising only moderately over the course of this year,” outgoing governor Glenn Stevens said on August 2 when the RBA cut its benchmark rate to a record low 1.5 per cent.   

That’s also wrong: in raw terms, CoreLogic’s five capital city index is up 7.2 per cent over the first eight months of 2016 and about 6.4 per cent if you adjust for the updated method they introduced to remove outliers. Over the first 238 days of this year, home values have appreciated at a 9.9 per cent annualised clip, or five times faster than wages and 6.7 times core inflation. They must grow great gunja inside Martin Place!


Listings sucked up


The RBA reckons we should not worry about future house price growth because “of the considerable supply of apartments scheduled to come on stream … particularly in the eastern capital cities”. Yet every too-smart-by-half that trots out this line when calling for a house price crash has forgotten that almost all these apartments have been pre-sold! They thus contribute very little to the volume of homes for sale. Sure, there will be a few flippers and some borrowers that banks foreclose on – but this will have a negligible impact on effective supply.


The RBA’s final argument is that “there has been a large decline in the number of transactions”. While this is true, any agent will tell you that demand over this four-year-long boom has sucked up most of the supply of listings. The fall in turnover reflects strength, not weakness.



Given its 90 per cent confidence interval on its forecast for real GDP next year is between 1 per cent and 4.75 per cent (ie, it has no clue), the RBA should heed its own assessments about its inability to divine the future and exercise more care when slugging savers with zero per cent real (after inflation) cash rates while economic growth is running above trend.


Which brings me to a presentation I gave during the week at the Portfolio Construction Forum. My case was that it’s possible to deliver relatively high returns of say 3-4 per cent above inflation with low risk in liquid assets that carry intrinsically modest yields.


If you bought a senior-ranking bond issued by CBA in the middle of the February bank credit conflagration and held it through to today, you would have earned raw capital gains of 1.4 per cent plus the roughly 2.75 per cent annualised interest rate the bond pays. You can’t compare the interest with the capital gain unless you do so on a like-for-like basis by calculating the trade’s “internal rate of return” (IRR), which is just an annualised return.


This investment realised a 5.5 per cent IRR over the 6.5-month holding period from an incredibly safe asset that can be sold to the RBA in an emergency via its liquidity facilities. Clearly you need to be able to repeat the pattern – identify cheap assets and sell them at higher prices – to maintain this performance.



Time value of money


Another example was buying CBA’s subordinated bonds in the days following Brexit in June, which if held through to today would have furnished 2 per cent capital gains on top of the 4.1 per cent annual interest the bonds pay. This translates into an unusually high 18 per cent IRR over the short two-month holding period on an asset that’s safer than hybrids or equities.


Why annualise trade returns a thoughtful adviser asked? Well, unless you account for the time value of money, you cannot objectively compare a 4 per cent return captured over three months with 4 per cent delivered over 12 months. One requires IRRs to assess trading strategies over different horizons.


Another queried why I was a zealous hybrid hater: I have been critical of these investments for their extreme complexity and for as long as they remained expensive. Yet as I previously explained in this column, a striking improvement in spreads coupled with a fundamental change in the supply outlook in June made hybrids compelling. I allocated to them in my own portfolio (following which spreads compressed 80 basis points), and more recently subscribed to the latest ANZ deal.



On the subject of cheap bonds, I like five-year senior-ranking major bank floaters right now as a near-cash substitute. Pre-GFC these incredibly liquid bonds were trading around 20 basis points over the three-month bank bill swap rate (paying 1.95 per cent interest in current terms). During 2008 they blew out to more than 150 basis points over, while the post-GFC “tights” were around 60 basis points in mid-2014 (or 2.35 per cent annual interest today).


Whereas the major banks’ subordinated bonds that I’ve highlighted before have rallied from 300 basis points over in February to around 180 basis points over today, the higher-ranking (or safer) senior floaters have noticeably lagged. At 100 basis points over, which translates to a 2.75 per cent annual interest rate with strong daily liquidity, they are still a chunky 40 basis points wide of their 2014 tights and much better than most at-call deposit rates.