Description

Long Australian Sovereign CDS (Bloomberg Symbol: AUSTLA CDS USD SR 5Y D14 Corp)

In some respects, this is an unfortunate time to be writing this pitch given the negative (and I thought unfair) comments the US President made about Australia today. Moreover, Australia is a terrific country and I in no way anticipate that it will go bankrupt. As I will discuss below, Australia has been more responsible than many other governments in terms of government borrowing over time. However, the goal for value investors looking to hedge is to find cheap insurance and, at this price, I think Australian sovereign CDS trading at or near their all-time lows represents cheap insurance in a compellingly asymmetric way. This can be used to juice a pre-existing short position or can be more of a 'moonshot' short position in its own right.

Pitch

Long Australian Sovereign CDS (Bloomberg Symbol: AUSTLA CDS USD SR 5Y D14 Corp) as either an addition to a pre-existing short Aussie housing position or as a short position in its own right. As some readers may have guessed, this is an idea primarily stemming from our thoughts around the Australian housing market. We think it is in a bubble and is unfortunately likely to burst with painful repercussions throughout the country. I will attempt to add a bit more color in the appendix but dman976’s 2/19/16 short pitch on CBA (Commonwealth Bank of Australia) gives a decent starting point on the bank short pitch and the build-up of household debt.  

While we like the Aussie bank short, the challenges are two-fold:

• The negative carry is high due to the dividend yields (eg >8% for WBC) and the timing is uncertain

• The downside is a bit hard to bound as it’s unclear exactly how much the banks will be holding the bag when and if the housing market goes down (especially if it does not violently implode)

There are no CDOs to short and Aussie bank CDS is fairly expensive (although admittedly getting cheaper), so where can we find some way to more attractively leverage our view?

We would submit that Australian sovereign CDS, trading at or near its all-time lows, represents an asymmetric way to do this:

To reiterate, we do NOT think that Australia is going bankrupt or anything like that. However, while government debt to GDP is low, it is rising quickly and is forecast to rise even more from here:

This recent rise happened during a period of strong GDP growth! If Australia’s economy was to hit the skids (potentially because of a housing slowdown or worse), this debt is likely to increase even further.

Meanwhile, the ‘Big 4’ Australian banks’ balance sheets are ~2.2x the size of Australia’s GDP. They are the definition of ‘too big to fail’ in the context of Oz:

If there was to be a major collapse in housing, the banks’ assets are 70% mortgages and they only have ~HSD% Equity-to-Assets. The average Aussie household is even more levered (see appendix below). Overall, the debt system-wide is much less comforting than the government’s admirably low debt-to-GDP would suggest.

In fact (as discussed in the appendix) Australian household debt is an outlier around the world. 

So who would take it on the chin if everything went to pot in the Australian housing market? We think the clear answer - in one form or another - is the Australian government. And we don’t think that distinct possibility is priced in to the CDS. Let's revisit what we're saying here. While - again - Australia is a terrific country that we would encourage you to visit (have a meat pie and a halal snack pack!) and that is highly unlikely to go bankrupt, this CDS is a risk-based insurance policy and we think that, during the 5yr duration of the CDS, the perceptions of risk (and the corresponding price of the policy) will go up, possibly dramatically.

We also like that Australian sovereign CDS can serve as general insurance against ructions in global financial markets. Because Australia is so dependent on foreign financial flows, it catches a cold when global money markets sneeze.

Returning to the price graph: