The good news is APRA and ASIC's commendable efforts to crush irrational exuberance in both lending and borrowing decisions---with firm backing from Treasurer Scott Morrison---has delivered a dramatic, albeit belated, shift in atmospherics. The property promoting media, often conflicted by their most valuable asset being online real estate portals, have duly published countless stories about the risks of lumping most of your wealth into a heavily geared asset that is 15 per cent to 30 per cent overvalued.

While a very early partial read, auction clearance rates were softer last weekend, which corresponds with the pronounced deceleration in price momentum. I expect this to continue over the rest of the year, which should alleviate the concerns of rating agencies animated by the blindingly obvious financial stability risks propagated by the RBA's cheap money policies.

There is a high probability that the annualised rate of house price growth in Australia over the next 6 months will be comfortably below the level Standard & Poor's has declared as its red-line, which is 6 per cent to 7 per cent in nominal terms.

This should be reinforced by a robust budget, burnished by a raft of structural cost savings and revenue upgrades that coupled with more benign growth in the private debt-to-GDP ratio should give rating agencies confidence to reaffirm the nation's AAA rating.

Major bank fair value interest rates above bank bill swap rate.

Where to find value?

This nonetheless begs the question: where can one find value across the capital structure? To answer the question we use a model that estimates the fair value, or the minimum required interest rates, that should be paid on bank deposits, senior bonds, subordinated bonds, and hybrids based on the institution's assets, liabilities, leverage, and equity volatility.

We assume that when assets cross, or converge close to, liabilities (ie, when equity is near zero), the security in question goes into default with the recovery rate determined by the empirical experience across different parts of the capital structure over the last 95 years. Asset volatility is proxied by combining historic equity volatility, which we conservatively set at one standard deviation higher than the 12 month rolling average, with the bank's current leverage.


We assume that default on a major bank deposit or senior bond does not occur until its equity goes to zero. This gives us an expected probability of default of 6 per cent that is much higher than rating agency inferences. Our research suggests that a 5 year major bank term deposit with a 100 per cent recovery rate pays fair value interest around the equivalent maturity government bond yield plus a very small risk premium for bank credit exposure.

A 5 year senior bond issued by a major bank with only a 47 per cent recovery rate is fair value at 0.63 per cent (or 63 basis points) above the bank bill swap rate. With the lowest volatility, CBA's senior bonds require the smallest interest spread at only 0.33 per cent (33 basis points) above bills. At about 95 basis points above bills today, senior spreads therefore look attractive.

Tier 2 subordinated bonds with zero per cent recovery and a default trigger at 5.125 per cent equity (or the so-called "non-viability" level) are currently trading around fair value paying interest spreads of circa 170 basis points above bills (ie, they are not cheap).

What is inexpensive are Additional Tier 1 capital hybrids, which even with the earliest default trigger at 7.125 per cent equity (a level at which APRA garnishes 60 per cent of a bank's earnings) and no recovery, require only a 190 basis point spread above bills compared to current spreads of 370 basis points. Even if we assume "extension" risk to a 7.5 year maturity, hybrid fair values are still only 243 basis points.

The author is a portfolio manager/director of Coolabah Capital Investments and Smarter Money Investments, which invest in fixed-income securities.