Australian Interest Rate Swaptions.....(Huh, you what?)

Some time ago, Our Man mentioned his bearish views on China (see A, B and C) and how he was looking at Australia (and especially Australian Interest Rate Swaptions) as a way to play any China slow-down.  Since Our Man is trying to pitch it to a few people, here's the thinking behind that idea, in all it's glory.

Thesis:
The markets expect that Australian interest rates will exceed 5% in 2-years time but I believe that they will be substantially lower.  Thus by purchasing an interest rate swaption that gives one the right (but not obligation) to receive, in 2-years time, interest at the rate of 4.5% on 1-year money will prove spectacularly attractive. 

Why do I believe it is mispriced?
a. Australian GDP growth isn’t entirely what it seems:
Australia is viewed as having escaped the Financial Crisis, with only 1 quarter of negative real GDP growth.  However, this belief ignores that Australia had 3 quarters of negative nominal GDP growth (please see graph below on right), implying that in 2 of those quarters prices fell even as volumes increased.


Australian growth benefited directly from an aggressive stimulus package (c$30bn, or 3% of GDP) and through the RBA cutting interest rates.  These measures had a significant impact on household disposable income, causing it to rise by 10% y-o-y to Sept-09, despite labour income (the largest component) contributing a mere 0.4% (per Gerard Minack of Morgan Stanley Australia, February 24, 2010: The Odd Expansion).  Minack estimates the primary factors behind the household disposable income growth were the stimulus package (4% increase to household disposable income) and the RBA’s rate cuts (5% increase).

b. Australian Private Debt Levels are similar to the US Peak
While Australia’s government debt (<25% GDP) is in good shape, the same cannot be said of Australian Household Debt, which has just crossed 100% of GDP, and over the last couple of years has surpassed even that of the US (please see graph below on the left; courtesy of Steve Keen's Debtwatch). 

The increase in this debt during 2009 was largely driven by an increase in the Australian First Home Owners Grant both at the federal (A$7,000) and state (e.g. New South Wales – A$3,000) levels.  However, unlike the US equivalent, the Home Owners grant can be put towards the deposit on a house, meaning that it is quasi-leveragable by reducing the down payment that the buyer must provide, from their own funds, in order to meet a bank’s LTV target.





c. Australian House Prices are in a larger bubble than the US was at peak!
The impact of the sharp rise in household debt on house prices is clearly visible; after consistently tracking CPI since the mid-80s, house prices in the major Australian cities rose sharply as household leverage increased (please see graph on right).

Given that sharp move in nominal house prices, it is not surprising that the recent 6th Annual Demographia International Housing Affordability survey ranked 3 Australian cities amongst the worst 4 globally (and 10 in the top 20).

The size of the move in Australian house prices is particularly stark, even when contrasted to other countries where we’ve seen housing bubbles (please see graph on left, courtesy of Steve Keen's Debtwatch and The Economist). 

In particular, it’s noticeable how the reintroduction and increase of the First Home Owners Grant by the Australian government in 2009 has had a far more pronounced impact than the US equivalent, and succeeded in not only arresting the fall in house prices but managed to drive them higher.

d.  China
Australia has been a major beneficiary of China’s aggressive stimulus during 2009; with China representing 25% of 09-10 exports of which around 2/3 are natural resources.  Thus the Australian economy, and Australian households, would be significantly impacted by any slowdown in China.  Since there is much discussion in the financial world regarding whether China is or is not a bubble, and as I personally believe that it is (see A, B and C), this trade represents a cheap and effective way to play the possible unwinding.

Timing
Now is the perfect time to put the trade on:
I.     Australian economic data has started becoming more mixed (e.g. Feb’s weak retail sales numbers).
II.    Australian banks have started to tighten credit and cut their Home Loan-To-Values (Westpac has cut their LTVs from 92% to 87%).
III.    The expiration of the increases to the Australian First Home Owners Grant during 2010 (many of the State supplements, such as those in Victoria and New South Wales, expire in June-2010).
IV.    The emergence of inflation in China, which is likely to lead to tightening of credit and rates there.

Why Australian Interest Rate Swaptions?
I believe that this trade represents an exceptional opportunity and the most efficient way to play both a slow-down in China and a decline in the Australian housing/credit markets.  The underlying reasons are:
1)    Time Horizon: The nature of the instrument means that the trade has 2-years, an exceptionally wide window, in which to work. 
2)    Risk/Reward:  As the trade is a swaption, the maximum loss is limited to the premium.  Furthermore, the swaption offers a large time window for my opinion to be correct, yet (like CDS but unlike equity options) the cost does fully represent the width of the time window.  Finally, interest rate swaptions (like CDS) do not price in significant tail events (e.g. Australia being forced to institute a zero-rate policy) due to their expected improbability.
3)    Liquidity/Reducing Counterparty risk:  Interest rate swaps, options and swaptions are exceptionally liquid products and traded by numerous banks, meaning the trade can be put on in large notional size and counterparty risk can be limited with each bank.
4)    The willingness of Western Central Banks to aggressively cut rates to support economic growth and to head off solvency/credit events (as seen in 2007-09) makes interest rate options an attractive investment.  This is even more true of Australian interest rate options because of the predominance of floating rate mortgages there, which means that interest rate cuts will directly increase disposable income.

For illustrative purposes (based on contacts from a number of investment banks):
Instrument: AUD2y1y 4.5% Receivers 
Cost: 12bps of notional; this also represents the maximum loss on the position
Return (if option exercised): (4.5% - Bank-Bill Swap Rate ) * Notional

Example: If Bank-Bill Swap Rate fell to c3.25% (i.e. the levels seen in 08-09), the return would be 125bps of notional, a c10x return on the invested capital.



Huh, you what?
You lost me at interest rate...let alone that whole swaption thingy...besides, even the E*Trade baby won't sell me those things.  Well, Our Man is in the same happy little boat, as far as this portfolio is concerned....it's just not easy to play a short thesis on Australia (and its banks/construction sector/home builders/etc).  The way Our Man's looking to implement it is probably be through options on EWA (iShares Australia).  However, given the general lack of options, the liquidity of EWA and their cost, it's a less attractive trade than the interest rate swaptions.  What does that mean?  Well, it means our timing has to be a lot better and our sizing is going to be smaller.  Rather than spent 100bips of premium steadily buying swaptions (that don't kick-in until 2-years after the purchase date) over the next 6-12months, Our Man's going to be looking at 3-6month options on EWA.  That means Our Man's certainly going to wait until the trend in EWA is down and the Australians have made their first rate cut, before looking at putting 25-50bips into the trade over the following months.

Thoughts on Water...

Our Man stumbled on Water as a broad theme many moons ago, ironically when spending his time reading far too many documents on peak oil.   Below are a collection of thoughts:

Less than 10 countries possess 60% of the world’s water supply
Canada is the most water rich country and China is the least water rich
China has about 7% of the world’s fresh water but has c21% of the world’s population
Investment-wise there is no such thing as a water sector, and so companies fall across traditional sectors

Thesis

• No substitutes for water

• Broadly fixed supply on planet, so must optimize usage.

• Looking at historical data we can see that demand grows exponentially (per capita) with industrialization, urbanization and standardization.

• Demand tied to agriculture grows as “wealth” grows. For example, it takes 1,300 litres to grow 1kg of wheat but 15,000 litres for the feed/processing that goes into producing 1kg of beef

Trends

• Conservation & Efficiency

• Recycling and Reuse

• Technological solutions

• Consolidation, Privatization and Outsourcing

Breaking down the industry

• As noted above, a clearly defined “Water Sector” does not exist.

• Thus it appears easiest to break the industry down into the following sub-sectors, so that useful comparisons may be drawn:

1. Water Utilities
2. Water Services & Industrial Stocks
3. ETFs

1. Utilities

• 80%+ of the population are served by municipally-owned and operated utility districts or by government agencies.   Our Man, as a Brit, finds this very strange…given than 80%+ of the population is served by private companies in his homeland!  Given the financial stress than many municipalities are under, there’s a reasonable probability that some of these water systems end up in private hands.  

• Unlike in Energy, Water Utilities are a true natural resource as Water can’t be distributed widely.

• Publicly-traded are regulated businesses, with steady cash-flow generation and dividend increases (e.g. Aqua America has paid a dividend for the last 60 years, and increased it 20 times in the last 19 years).

• Clean Water Act and Safe Drinking Water Act increased standards.  The EPA estimates that up to $70bn of ratable capex is required over the next 5 years.

• This capex would be included in the Utilities ratable asset base, allowing the firms to generate a guaranteed rate of return on their investments.

2. Water Service & Industrial Stocks

• Services stocks participate in the existing water system by providing services towards the collection, conveyance, treatment and monitoring/analysis of water and wastewater.

• Services companies generate their revenues from activities including: Flow Control Systems, Metering, Water Treatment, Irrigation and Ownership of Water Assets.

• The end-user for these companies will tend to be the Water Utilities.

• Industrial Stocks could potentially benefit from the increased capex in the Water Utility space.  AWWA estimates that Utilities will need to spend $10-15bn a year (for the next 20years) to replace aging pipes and plants.  The major beneficiary appears likely to be pipe stocks due to the substantial need for replacement (old pipes have a leakage rate of up to 50%) and the size of the pipe network (1mn miles, or 4x the National Highway System).

• With a number of major countries introducing legislation (e.g. China has budgeted $128bn for water infrastructure in its recent 5-year plan), large international players stand to also be beneficiaries.

3. ETFs

• There are 4 major water ETFs available; CGW (Claymore Global Water), FIW (First Trust ISE Water) and PIO (Powershares Global Water) and PHO (Powershares Water Resource).

• FIW and PHO are US-centric ETFs, whereas CGW and PIO are far more Global.

• PHO and FIW have a lot of overlap in names, but differences in the methodology (modified market cap weighted vs. modified equal-weighted) means that PHO has a greater bias towards smaller cap names.  Finally, PHO is substantially larger ($1.4bn) than FIW ($50mn), which affects the spread and liquidity of the instruments.

• CGW and PIO both have <40% in the US, with the balance spread globally.  Additionally, they both have a far higher allocation towards Utilities (c40% vs. 25-30% for the US focused ETFs).

Overall, Our Man expects ETFs to be the first step to gain some exposure to this theme and start a “Water” bucket in the portfolio.

Q1-10 Thoughts

I’m hoping to be better at jotting down things, as I think of them over the next quarters, in the hope that there will be more structure (and some would say point) to these quarterly musings.  I say these, though obviously this is the first quarterly musing and in truth it’s more of collection of thoughts that I’ve pondered at various times since the middle of last year.  So, in no particular order, here we go:

Levels versus Changes
Generally speaking, we’re conditioned to look at the changes in things -- the S&P is up 0.67% today, Retail Sales were up 9.3% in March, Company X’s revenues were up Y% year-on-year, etc.   This makes sense in a world where things steadily increase, hence its prevalence.  However, given the depth of the recession, surely it makes more sense to keep the levels firmly in mind to.  The (same store) retail sales numbers were clearly good (at +9.3% yoy) but the level of those sales is below the 2006-2007 levels, somewhat less impressive.  At the end of the day, while we all focus on the changes as a short-hand for looking at the current situation, it’s the levels that matter…

Retail Sales
Speaking of retail sales, having the data is one thing but dealing with the major conflicting data and then trying to interpret it is another.  Clearly same-store sales have improved – I certainly don’t doubt that; but how much of that is as a result of stores being closed.  After all that improves the numbers in a couple of ways:
- Companies close down their under-performing stores (hence the average performance improves)
- Customers (some of them, at least, assuming brand loyalty) of the closed store go to one of the remaining stores, and hence same-store sales (for the remaining) look better than the underlying reality. 
But…given the rosy sales (and general consumption) data why are sales tax receipts so weak (here’s Texas, as an example...NY is the same)?
And why’s Wal-Mart (a price leader in many categories) looking to cut prices further. 
And why are other measures of consumer spending so muted?
Maybe, I’m just overly skeptical…

Treasury Bonds, Households and Say’s Law
It’s probably not surprising, given their size in the book, to hear that I ponder a lot about Treasuries and the 30-year yield.  Certainly, there’s been no change to the underlying thesis (a secular debt-reduction driven deflationary/disinflationary period) and circumstances seeming to back this up with both Commercial/Industrial Loans and Consumer Credit continuing to contract.   No, my ponderings have been more related to Households and if/when we’ll see a shift in their allocation towards Treasuries.  Currently, Households hold the substantial majority of their assets in equities and real estate, with barely a sliver in Treasuries. 

Demographics, with the median age of the boomers starting to creep into the late 50’s, would suggest that we should expect some shift from capital appreciation towards income generation.  Over the last year we’ve seen some of that, with a steady inflow of assets into fixed income funds and out of equity mutual funds, despite the strong rally in the equity markets.  Is it possible that Say’s Law will apply to Treasuries – can supply, really create its own demand...

Mandelbrot & "Trading Time"
Finally, an observation; I’ve been re-reading some Mandelbrot recently.  In particular, various things he’s written on trading time; the recent 4-6 weeks being a good example of “slow” trading, where things have meandered casually (never particularly dramatically) higher each day and yet, here we are up 12%+ in barely 8 weeks later.  For me, it’s been the time for working on researching future positions rather than actually doing anything with the book (which is flat over that period).  Hopefully, that research will come in handy when valuations are more to my taste and we’ll see some “fast” trading time soon.

And, yes I know I switched from the 3rd person…I think I’ve grown tired of it, for a while at least.

March Review

Performance Review
March proved another lackluster month for the portfolio, ending down 61bips (putting the book down 1.12% YTD), with the book’s defensive posture proving a negative.  The largest negative contribution came from the Long Treasury positions (down 77bips), after yields increased across the curve towards the end of the month.  The position in the Bond Funds bucket was also impacted by this, down 9bips, but was only a minor detractor.  On the equity side, the defensive positions in equity puts (down 52bips) was a large negative contributor, but this was entirely counter-balanced by strong performance of THRX (in the Valuation bucket).  Elsewhere, the positions in Other Equities (+20bips) and Absolute Value (+0bips, though the NCAV names did earn back their transaction and commission costs in the 2 days they were in the book) helped performance.

Portfolio
41.4% - Long Treasury Bonds (19.8% TLT and 21.6% in the Aug-29 Bond)
14.5% - Long Bond Funds (6.8% HSTRX, and 7.7% VBIIX)
3.8% - Other Equities (1.8% NWS, 1.8% CMTL, and 0.2% SOAP)
3.2% - Value Idea Equities (3.2% THRX)
1.5% - Absolute Value/NCAV stocks

-3.1% (delta-adjusted) – Put Options (0.43% of premium in S&P put options and 0.38% in a GS put option)

34.8% - Cash