A More Festive Season for Australian Income Investors

A More Festive Season for Australian Income Investors
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A More Festive Season for Australian Income Investors

What a difference a quarter makes. Only a few months ago, Australian investors faced overheating property markets and, with the cash rate at a record low, dwindling sources of income. Today, property prices appear to have peaked and attractive income opportunities are surfacing.

What happened? The effects of higher capital requirements for Australia’s banks are starting to ripple through the markets.

Back in June when property prices were climbing, PIMCO’s Laura Ryan and Aaditya Thakur found that Australian borrower confidence was dominated by two factors: the level of interest rates and recent changes in asset prices (see “A Look at Rising Household Debt in Australia and the Implications for Policy”). When interest rates were coming down and property prices were going up, Australian borrowers exuded confidence, and auction clearance rates and home prices reached record highs.

Even when borrowing rates on investment properties started to edge upward and China was adjusting to its own slower-growth trajectory in July and August, credit remained freely available to retail borrowers (see “Australia’s Property Markets Versus the New Normal’s Gravitational Pull”).

Fast forward just one quarter and mortgage rates for owner-occupiers, not just investors, are going up and property prices appear to be faltering. APRA (the Australian Prudential Regulation Authority) said in July that it will raise the risk weightings on mortgages in 2016, and as banks start to hold more capital against them, the wider wedge (or margin) between the official cash rate and mortgage rates will likely become permanent and borrowing rates will stay higher.

As a result, the two key drivers of borrower confidence are going into reverse, which implies, watch out below for property prices. And the wealth effect supporting consumption may quickly turn to restraint. If the Reserve Bank of Australia needs to provide more support for the economy, then term deposit rates will also come down further.

The good news: For a long time, PIMCO has been bearish on Australian retail bank hybrids because spreads were not fully compensating investors for the myriad risks, including their subordinated status to other debt. However, as banks further bolster their capital positions ahead of more regulations expected next year, pricing of new issuance is now reaching “fair value” territory for investors.

What does all of this mean for investors? While the cash rate will likely remain low and may fall further, income opportunities in the Australian capital securities space have improved significantly. But it is crucial to diversify. Combining Australian bank stocks, bank hybrids and residential investment property does not equal a diversified portfolio; rather, they are arguably one leveraged position on the outlook for Australian residential property prices. More broadly, global credit and global capital securities, issued by banks specifically to raise regulatory capital, offer income that is less correlated with both the outlook for the Australian economy and investors’ dominant portfolio position – equities. This is an opportunity that should bring cheer to Australian investors.

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Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. The value of real estate and portfolios that invest in real estate may fluctuate due to: losses from casualty or condemnation, changes in local and general economic conditions, supply and demand, interest rates, property tax rates, regulatory limitations on rents, zoning laws, and operating expenses. References to asset class correlations are based upon data over a certain time period. These correlations may vary substantially in the future or over different time periods that can result in greater volatility. Diversification does not ensure against loss. Investors should consult their investment professional prior to making an investment decision.