Observations on Bank Hybrids

Generally I am skeptical of hybrids, particularly the highly structured preference shares issued by financials (mainly the big 4 banks).

I would never participate in a new issue as the are typically overpriced and trade poorly in the secondary market. They are sold in general to in a fairly unsophisticated manner based on yield, despite being complex securities.

It's important to note that while they may look like a fixed interest product (the holder receives regular payments and if all goes well a return of capital at a specified future date) they are more akin to equity. In periods of market distress (now) fixed interest securities as a group generally rise while equity-like hybrids fall. This is possibly due to investors switching From the hybrids into ordinary equity to capture the higher yields on offer. This is quite a disadvantage as they are not providing any diversification benefit to a portfolio. To verify this for yourself, check out WBC vs WBCPE (hybrid) and WBCHB (bond).

WBC

WBCPE (hybrid)

WBCHB (bond)

All three securities have declined over the last 12 months. The bond has done best and importantly has exhibited the lowest volatility and greatest degree of capital stability.

Having said all this there are some opportunities from time to time.

ANZPA will mandatorily convert in Dec 16 at a 1% discount if not redeemed. Currently they are trading at a margin of about 3.9% to bills (i.e. based on a bill rate of 2.1% the yield to maturity is c.6.0% – note this will fluctuate as bills move). I like it under $99 and like it more under $98. I would reassess these levels if ANZ trades below c.$25. It is a very liquid issue having $1.7bn of securities outstanding.

If there is interest I will write about another opportunity. Let me know in the comments.

Good luck

Ed

 

Weekend action 9-11 June: implications for Australian investors

Over the weekend a rescue was announced for Spanish banks. China also released data that was interpreted by the markets as broadly ambiguous (eg inflation data indicated that the economy may be cooling more than expected).

After the obligatory bounce reality set in. All key risk markets reversed eg the S&P (ES futures) moved from +1% to -1.5% on heavy volume with major US financials dropping 5-7% from open. Oil moved from +3% to -3%. EUR gave back all of its 180 pip rise and more. The S&P Volatility Index (VIX) closed at 23.56, +2.33 but not as high as a week ago.

Charts

Implications for Australian investors

Generally, the market has welcomed bailouts (with good reason – the punchbowl is being passed around so the party can continue). The extremely negative response to ‘good’ news is concerning. My opinion is that, ‘risk’ is going to underperform until there is some definitive progress made in Europe (read: massive coordinated intervention on a scale required to deal with the problems). It is also likely that the newsflow will be unsympathetic (eg I expect on other countries to demand assistance without austerity, which in the first instance is likely to be rejected).

I do believe that defensive, low beta equities (utilities, property trusts, and defensive industrials ) will continue to outperform as investors seek lower risk income and defensive characteristics in an environment of declining cash rates.

I also believe that gold priced in AUD is likely to outperform over the medium term (1-3 years). Currently markets are only holding together because of of a belief that the central banks will intervene if required (i.e. the Bernake Put). Action over this weekend strongly implies that words alone are not going to have the desired affect for too much longer and actions, on a significant scale, are required to stabilise markets. This is positive for gold.

Happy investing

Ed

PS Please read the site disclaimer.

ASX market comment 1 June 2012

May was a bad month on the ASX, with the market down 7.3% (worst month since May 2010 … May strikes again!). I’m sure many investors are keen to turn the page into June!

Yesterday the market put in a decent showing with the XJO down a measly 12 points (-0.3% to 4064). Hardly significant or meaningful. However what got me thinking was some comments I received that the market “felt” a lot worse than it actually was. So I decided to examine the performance of the most liquid stocks (average value traded per day of over $5m). There are 111 such stocks. I then looked at the performance of the 20 “riskiest” stocks (measured by beta) vs the 20 most “defensive” stocks. The results summarise in the chart below:

Fairly remarkable. On a day when the market was essentially flat, risky stocks returned -2.9%, while defensives were unchanged. (Outperfomers included TLS and the banks).

Reasons I can suggest for this:

  1. The macro environment is obviously poor (negative headlines everywhere, Chinese data at 11am was also perceived negatively).
  2. The equity market is pricing in further interest rate cuts. In this environment defensive stocks will outperform handily.

I would suggest defensive stocks could be accumulated on weakness. On my watch list are property trusts and utilities that pay quarterly or semi-annual distributions in the last week of June (most of them but not for example WDC). I will also be looking at liquid industrial stocks that pay dividends in August and early September (eg TLS, CCL, WOW, AMC, ANN). Its important that the stock should be very defensive … this excludes mining, mining services, energy, consumer discretionary and media stocks for example.

I won’t be rushing though – last night the S&P 500 was -2.5%, the worst performance in 7 months. So there’s probably time to get set …

Happy investing

Ed

PS Investing and trading involves risk. Please read the site disclaimer.

Friday, I’m in love with you

Relentless bad news

Right now, investors have to get used to a relentless torrent of bad news. One minute its weak Chinese data. The next its the possibility of the Greeks exiting the Euro. Or Spanish bond yields climbing over 6%. In the past few years we’ve really witnessed all kinds of trials … from tsunamis and volcanic ash clouds to debates over raising the US debt ceiling and talk over bailouts ….  The mood is definately subdued and financial press is continuously “glass half empty” (in Australia that is … watch US financial TV and you will find hopium is everywhere .. but that’s another story).

The Aussie market gets the wobbles

Most Aussie investors know that we take the lead from overseas – historically the US, but now also Europe and China. And for whatever reason, the worst news of all seems to be delivered over the weekend! So in a risk averse environment (now), Friday is often a dud day on the ASX as “the market” anticipates various weekend crises. Come Monday, the market can see a good “catch up” rally if the anticipated bad news doesn’t occur.

So I’ve turned my mind as how to profit from these situations using options. There are a couple of strategies. I’ll work through an example now.

Case study – BHP on Friday 18 May

On the Thursday 17th of May, the US market was weak, with the S&P 500 closing down 1.5%. Following this poor showing, and anticipating further carnage over the weekend, the ASX was down 2.7%. One of the worst stocks was BHP, which closed at $31.46 (- 4.0%).

The chart below shows BHP with the relevant data highligted. Click on the chart to open it in a new window.

The effect of this drop was that volatility increased significantly. The composite implied volatility for BHP rose from 30.3% to 36.5%. As can be seen from the chart below, volatility over 30% is relatively high (but certainly not unprecedented).

Suggested trade

In order to exploit this increase in implied volatility, one strategy is to sell a strangle. I chose to sell $35 call options and $26 put options for a combined credit of 54c per contract, excluding brokerage. Based on 50 contracts, this resulted in a credit of $2700 to my account, before brokerage and fees of $30. I required $17,000 available margin to do this strangle. The diagram below shows the payoff at expiry on 28 June 2012. More technically minded readers will note that the implied volatility for the put is 54% and for the call is 33%.

Summary of this trade

A credit of $2670 is received when initiating this trade. At expiry, the full credit is kept provided BHP remains within the range $26 to $35. So in essence when we initiate this trade we want two thing to happen:

  • Realised volatility to decline. Simplistically this means we want the stock to go “sideways”. Of course “sideways” is a relative thing … but as a rule of thumb if the stock ranged between $30.50 and $32.50 in the two weeks following the trade, that would be fine
  • Implied volatility to decline. If the market become less anxious, and the stock moves sideways or increases, implied volatility will usually decline. As an option seller this is good for us. Lower implied volatility means that the options will depreciate.

Trade mangement

This is not a “set and forget” trade. When we set out to do the trade, we had in mind a desire that the stock move sideways and implied volatility decline. If either of these things don’t happen we will have to take action. One thing we can do is buy back both the options and close the trade. One guide as to when to buy back the options is when either option doubles in value. So in this case we received 27c per option. A good guide is to consider corrective action when either option is over 54c.

Outcome

Its impossible to know what will happen to this trade, since it expires on 28 June 2012. However, one week later the results have been very good. Composite implied volatility has dropped from 36% to around 30%. BHP was relatively stable over the week, closing at $31.61 (+0.5%). As a result the spread has depreciated by about 60% to around 22c. We can book a profit of $1540 if we buy back the options. Or alternatively hold the position and hopefully accrue further gains.

Happy investing!

Ed

PS Option trades can involves losses. Please read the site disclaimer.

ASX Macro View Week Ending 18 May

Since my last review in Feb, the S&P/ASX 200 (XJO) has slumped after attempting to break out to the upside though the 4400 level. For much of this period the market was in a slow grind, with little impulsive price action (positive or negative).

Since peaking at 4449 on 1 May, the XJO has sold off aggressively and is currently at 4047.  In the week ending 18 May, the market was down 5.6% in broad-based selling. Only the utilities sector escaped the carnage (+2.12%), however this was aided by the takeover offer for Hastings Diversified (HDF), up 12.8% for the week. Biggest loser among the largecaps was Toll Holdings (TOL) down 23.2%.

Why the drop?

The market has caught the nerves due to uncertainties in Europe (again). In addition, admission of over $2bn in trading losses by JP Morgan has not assisted confidence.

It should be noted that May and June are historically weak months, as 3 of the big 4 banks have gone ex-dividend and underperformers are typically aggressively sold as investors realise tax losses.

Where to from here?

I see weakness with an approximate target of c.3800 by 30 June. A lot obviously depends on the resolution (or lack thereof) to the European problems.

I think rallies will be short lived and could be viewed as selling or shorting opportunities.

Chart

Below is a weekly chart of the XJO since the market peaked in 2007. We are still in a secular bear market with the rally from the March 2009 lows essentially stalled and the market remaining approximately 40% off its all time highs in November 2011. Click on the chart to open it in a new window.

Ed

PS Please read the disclaimer before taking any action.