Bank stocks' hidden strength

There’s one thing that rarely gets a mention when talking about dividend cuts.

Summary: Talk of the big four banks cutting their dividends ignores two major points: that dividends have been slashed by all four major banks as recently as 2009, and dividend yield projections are being calculated on current share prices, rather than the price at which an investor paid for a stock.

Key take-out:Very hefty yields still exist in the banking sector even while factoring in potential cuts - they are still a valuable asset for many SMSF holders in particular.

Key beneficiaries: General investors. Category: Shares.

Being one of the millions of Australian investors who own at least one of the big four bank stocks is not much fun at the minute.

The big four are on the nose on the stock market – down almost 25 per cent on the highs they reached in March-April last year (led by ANZ and NAB, both down by 30 per cent.) Their interim results were uninspiring, to say the least: all up, the big four banks brought in interim FY16 profits 2.8 per cent lower than FY15, at $14.9 billion, slammed by a 49 per cent rise in bad debts, flat margins and a increasing capital requirements.

The residential property market is tepid overall, and much worse in places – for example, Western Australia. Settlement risk on apartments in Melbourne and Brisbane is alarming. And rising capital requirement have the big four banks under pressure: last year, the major banks raised almost $20bn in capital, but according to broking firm CLSA, they remain $33bn short of Tier 1 capital – which could force them to cut their dividends.

Cuts? To bank dividends? Perish the thought!

Bank dividends are sacrosanct to the nation’s army of self-managed superannuation funds (SMSFs), but investors cannot afford the luxury of a short memory on this score. Like any company, the banks can cut dividends, in fact they did so as recently as 2009 – for the same reason as that which has some analysts worried now, namely bad-and-doubtful debt provisions.

Back then, Commonwealth Bank cut its payout by 14 per cent, Westpac reduced its dividend by 18 per cent, and shareholders in ANZ and National Australia Bank suffered 25 per cent dividend cuts. Outside the big four, Macquarie Group shareholders had to swallow a 46 per cent dividend fall, while Suncorp slashed its dividend by 63 per cent as it also struggled with bad debts.

In fact, the consensus view of the broking analysts that follow the big four banks (as collated by Thomson Reuters) is that at least one – ANZ Banking Group – will lower its dividend payment this year (FY16), from $1.81 in FY15 to $1.60 both this year and next.

The analysts’ consensus projects National Australia Bank maintaining its FY15 dividend of $1.98 this year and next, while Westpac and Commonwealth Bank are expected to lift payouts. Westpac, which paid a dividend of $1.86 for FY15, is seen lifting that to $1.88 in FY16 and to $1.90 in FY17. Commonwealth Bank, which paid a dividend of $4.19 for FY15, is seen as paying $4.20 a share in FY16, and increasing that to $4.23 in FY17.

Lowering the dividend will take ANZ’s dividend yield from 6.68 per cent to a projected 6.28 per cent in FY16 and FY17, which grosses-up to 8.97 per cent. That is still pretty handy when compared to Thomson Reuters’ estimate of the market average gross yield, of 5.48 per cent (for FY16) and 5.81 per cent (for FY17) – and positively opulent compared to the cash rate, currently 1.75 per cent.

At a maintained payout of $1.98, the consensus has National Australia Bank trading on a dividend yield of 7.29 per cent in FY16 and FY17, equivalent to a gross yield of 10.41 per cent.

The dividend expectations for Commonwealth Bank have it trading on a fully franked yield of 5.43 per cent in FY16 and 5.47 per cent in FY17, equating to gross yield of 7.75 per cent and 7.81 per cent respectively. For Westpac, the expected dividends imply yields of 6.12 per cent in FY16 and 6.18 per cent in FY17, augmented to 8.74 per cent and 8.83 per cent respectively in grossed-up terms.

For a sector that is not wholly in favour, those are very hefty yields – and they show why Australian retail investors are not going to lose faith in the banks in a hurry. They are bedrock income-generating assets in many portfolios – in particular, in SMSFs – because the refund of franking credits (partial refund for a fund in accumulation phase, refund in full for a fund paying all of its members a pension) is a massive free-kick to SMSFs from the tax system.

But there is one more aspect of the bank stocks’ dividend yield story that rarely gets a mention, and that is that when you see the banks’ dividend yields calculated, it is almost always done using the current share price.

You read this in articles all the time: I am even writing it right now – if CBA pays the expected FY 2016 total dividend of $4.20, then at a share price of $77.50, it will yield 5.42 per cent, which grosses-up to the equivalent of 7.74 per cent.

Except that is not the yield of CBA shares.

The yield on CBA shares – on any share – depends on what you paid for the shares.

Sticking with CBA, it is quite possible that you bought the shares two years ago, at $61.15. Or four years ago, at $49.42. Or 20 years ago, at $9.87. Each of these situations results in a hugely different yield.

If you bought the CBA shares two years ago, at $61.15, the expected FY16 dividend of $4.20 would represent to you a yield of 6.87 per cent – which equates to a grossed-up yield of 9.8 per cent (in pension mode in a SMSF). If you bought the shares ten years ago, at $49.42, the FY16 dividend yield would be 8.5 per cent, which grosses-up to 12.1 per cent.

And those who bought the stock 20 years ago, at $9.87, and still hold it, are expecting a FY16 yield of 42.6 per cent – equivalent to a cool 51.7 per cent if their CBA stock is held in accumulation phase, and a staggering 60.7 per cent if it stock sits in the pension account of a SMSF.

After recent fiddling with superannuation tax arrangements, no-one could expect the tax treatment of SMSFs in accumulation and pension phase – or even dividend franking itself – to be inviolate. But while these exist, you can see why, to some investors, a dividend cut from the banks is not such a big deal.

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