Saturday, May 02, 2009

An arbitrage opportunity?

I am in the process of refinancing two of my mortgages. The best rates currently on offer work out at about 1.2% pa (1 month HIBOR + 0.7%) which is, by any measure, extremely cheap money. Many investments will offer yields which are materially higher than 1.2% including:

1. the Hong Kong Tracker fund: 4%

2. HSBC long dated bonds: 7.2%

3. many Hong Kong listed shares: dividend yields of 5% or better

4. residential property: net yields of 4% or better

There is at least some temptation to draw down against the equity of some of our properties to take advantage of the yield gap. Of course, this is not a risk free proposition. Taking the HSBC long bond as an example:

A. interest rate risk #1: the mortgage finance is priced at the short end of the money market. The long bond is priced at the longer end. If interest rates rise, the cost of the mortgage will rise while the yield on the bond remains the same;

B. interest rate risk #2: rising interest rates will lower the market value of the bond - meaning there would be a capital loss on resale;

C. credit risk: if HSBC became insolvent (or if its credit rating deteriorated) the market value of the bond would decline;

D. bid offer spread: even if B and C did not eventuate, the Hong Kong bond market is relatively illiquid, meaning that the bid offer spread is wide and a loss would be taken if I decided to sell the bonds;

E. cash flow mismatch: the bonds pay interest only. The mortgage will be P+I which means that there will be a negative cash flow to maintain. (Interest only mortgages are hard to come by in Hong Kong.)

Given that I have a significant amount of cash in the bank, this is somewhat academic but the possibility of taking advantage of the yield gap would otherwise be very tempting.

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