Hedging the house
There is much nervousness in South African property markets. Homeowners – many of whom are geared to the hilt – are worried that the property market has run too hard, and a market crash may be looming.

Fortunately, there are ways in which property market profits can be realised without calling an estate agent and suffering the indignity of hordes of people trampling over your property. The recent launch of specialist interest rate derivatives exchange Yield-X has prompted the introduction of a number of interest rate products with hedging characteristics (to hedge an asset simply means protecting yourself against a fall in its price). Bond futures fall into this category.

In order to understand why bond futures are effective property hedging tools, it is first necessary to highlight the similarities between bonds and property.

The vast majority of property is funded by home loans, the monthly repayments of which are affected by prevailing interest rates. Therefore, a change in interest rates has a direct bearing on the value of property. The value of bonds too depends on interest rates. Bonds pay fixed monthly amounts to holders; the price of a bond depends on the value of these repayments relative to alternative forms of income, which are in turn dependent on interest rates.

To summarise, the value of both bonds and property are largely dependent on interest rates. If interest rates go up, the prices of both asset classes fall. If interest rates fall, prices of bonds and property rise.

It is possible to protect yourself against a fall in the price of your property by taking a short futures position on bonds to the same value. Taking a short position means you stand to profit from a decrease in prices.

For example, imagine Bob, a Dainfern homeowner who, over the past two years, has seen surrounding house prices double. Bob reckons he could get roughly R3-m for his house if he were to sell. But Bob is nervous that interest rates may rise, with a resultant negative effect the size of his monthly home loan repayments and hence the value of his property.

Bonds are denominated in values of R1-m. Thus, in order to hedge against a drop in the value of a house worth R3-m, Bob must take a short futures position over three bond futures. He calls his stockbroker and opens a short position over three benchmark R153 government bond futures.

If interest rates rise, Bob should make a profit on his futures position roughly equal to the value of the increase in his monthly home loan repayments and the decrease in the value of his property. The opposite would be true if interest rates fall: Bob’s bond futures position would reflect a loss similar to the amount of money he stands to gain in decreased monthly home loan repayments and further increase in the value of the property.

It is important to note that bond futures are not the only product designed to hedge against interest rate risk. Each product has its own advantages and shortcomings; bond futures are no different. JSE director of equities and derivatives trading Allan Thomson explains that not all interest rates are equal: the R153 bond yield reflects a five-year interest rate whereas home loan rates are based on very short-term interest rates. However, Thomson explains that short-term and long-term interest rates are often highly correlated.

Another property of bond futures is that profits and losses are reflected immediately. By contrast, the effect of interest rates on home loans takes years to play out. For this reason, bond futures offer a suitable hedge against a decline in the value of an asset, but are less suitable for protecting against increases in monthly home loan repayments. A product better suited for this type of protection is the J-Note, which allows holders to swap variable interest rates for fixed ones over a period of time.

Article by: Julius Cobbett - www.moneyweb.co.za