Which should perform better over the next five years - the Case Shiller home price index (for selected regions) or a 5-year Treasury?
Given the higher risk of associated with home prices, one might expect home prices to generate higher returns. However, given that forward curves in selected CME Case Shiller home price index futures have been flattening (due to many reasons including -possibly -more natural shorts than natural longs), they may currently be either: 1) an opportunity to buy 5-year home price exposure, flat to Treasury yields, 2) a clean, pure-play on home price expectations, and/or 3) a relatively attractive (albeit un-leveraged) alternative to trending co-investment programs .^1 With the upcoming launch of the Nov 2024 contract, five-year exposures will be possible.
I appreciate that many investors may not be able to transact in derivatives. However (in theory, and given a minimum sized trade), one could combine a forward position in a Case Shiller future and cash (paid up-front by an investor) to create an ETF or credit-linked note (CLN). An investor's exposure would be to the quality of the collateral, with the CME as counter-party on the futures contracts.^2
The table below shows offers on the HCI (10-city index) and three regional contracts for the Nov '22 and '24 expirations. (Note that I'm estimating where Nov 2024 contracts (X24) will be offered when the CME opens trading later this month.) ^3
As a hypothetical example, an investor could have the exposure of the HCI index over the next three (or five) years vs today's spot level. That is, they'd earn a point at maturity for every point that the HCI index closed at maturity above 230.83, but would have a principal reduction of one point for every point is settled below. (The value of "a point" would be determined by the unit size of an offering.)^4
I'm showing CHI, LAX and NYM as they have had the weakest forward curves of the ten regional indices, and therefore their forward prices have drifted down to near break-even with Treasuries. If yields were higher (e.g. collateralized by a CD or corporate IOU) either gearing could be introduced on the LAX contract, or the base strike could be lower still.
Alternatively, for those that could use derivatives, or embed derivatives in a structured product, it appears that one could construct a total return swap (receiving the performance of the spot index, while paying the return of a Treasury) over a five-eyar horizon.
Other CME Case Shiller regional indices might also be used, but (since forward prices are relatively higher to spot) the strike price would have to be raised. Other regional indices could be used, but then counter-party risk (of the issuer) would need to be addressed.
Further, an investment (in either ETF or CLN format) might be attractive relative to some of the co-investment platforms that are currently ramping up.
*The maturity of an exposure is fixed and known, not allowing for any uncertainty of early refinancing. ^5
*The collateral is known, so there would be no need to evaluate prices (or borrower behavior) on individual properties.
*There are public prices on the reference obligations (i.e. futures). That should assuage concerns about NAV, and the work required (either by management or investors) to value collateral. As such, more than the issuing dealer should be able to evaluate (without detailed knowledge of underlying collateral) and trade.
*Deals might be ramped up more quickly (assuming, as today, that there are entities looking to sell forward contracts as a hedge against future sales, production, and/or home flips).
*An ETF/CLN product could be traded, or since value depends on the Case Shiller value at maturity, be hedged with futures contracts. That is, should forward home price expectations rise, and futures follow suit, the products and/or futures might rise in value.
* Bid/ask spreads on futures exist today (about 2% for 4 year quotes, 1% on 2 year expirations) even with limited liquidity. Creating a ETF/CLN structure should only improve liquidity in the CME futures.
Finally, as I noted above, and as I've argued in prior blogs (Sept 19 and Oct 4) CME futures may trade at levels that are below expectations. This trade might exist because hedgers may be willing to sell below expected forward prices as their business model is improved (and bankers are happier) with forward hedges in place.
Feel free to contact me about this blog, or any other aspect of hedging home price indices.
Thanks, John
^1 Forward curves have gone inverted as recently as winter 2018-19, so there is no floor to how much they might flatten. Also, I'm a fan of co-investment programs, particularly for borrowers who might either need help with the down-payment and/or who have a high personal cost-of-capital. This blog focuses solely on how a hypothetical end-product might compare with that to be offered by a co-investment program.
^2 I've used Treasuries as an example here, but an issuing entity might choose other obligations. Investors need to be comfortable with the collateral and/or quality of an issuer's guarantee.
^3 Calendar spreads for Nov '20/ '22 are lower than the suggested levels, but a) have been higher in the past, b) 2022 prices might reflect recession concerns, and 3) I have more sellers that buyers (at "expected" prices).
^4 For example, a point on a CME futures contract is $250, but a point on a $25 stock might be 10 cents. Higher limit prices (e.g. $250 per share), or CLN denominated in $10,000 minimum units might be necessary to overcome any trading fees charged by brokers.)
^5 The longest CME contract is 5 years.