Banks are back on the menu

PORTFOLIO POINT: If the Reserve Bank keeps rates on hold, owners of bank shares and long-dated term deposits will do well.

We are seeing a dramatic shift in the outlook for Australian interest rates. Accordingly, many Eureka Report readers would be wise to adjust their investment strategies as long-dated term deposits and bank shares become more attractive.

For most of this year analysts and economists have been forecasting at least two more interest rate rises totalling 0.5%, and many forecasters believed that over the next year or so there would be as much as a full 1% rate rise – predictions that were reinforced by the sentiments coming out of the Reserve Bank at regular intervals.

Many commentators who had close contacts at either the Reserve Bank or Treasury were told the same privately and followed their guidance. But anyone who looked at what was happening in the non-mining or real economy knew these predictions would lead to disaster.

The Reserve Bank has slowly arrived at the same conclusion and as this happened we have seen a softening of its statements, a lowering of growth forecasts and a move to a more neutral stance.

For some months now the data flow has been dominated by poor retail sales and this is now flowing through to their suppliers. Unemployment is steady but the number of hours worked has slumped. So far the business community has had to take it on the chin.

Adding fuel to the fire have been the over-leveraged new-home owners, who are struggling under comparatively higher interest rates, growing power bills and higher costs elsewhere in the family budget. The idea that we might be facing even more rate rises in the future had them tightening their belts even further and accelerated savings levels to multi-year highs.

I have been warning the Reserve Bank of the consequences of higher rates for some time now and last week I was joined by Westpac’s chief economist Bill Evans, who forecast a cut before Christmas and more to follow in the new year.

The Reserve Bank’s new stance has been motivated not only by what has been happening on the local front, but also by concerns about what is happening in Europe and the US plus the efforts of China to reduce inflation, which are beginning to take hold.

The most likely event on the horizon that would see rates move up is a major collapse in Europe, which might affect the cost of borrowing for Australian banks. It is hard to accurately weigh up the longer-term chances of a European meltdown but the immediate crisis seems to have been averted.

But what I really want to do is put aside the international challenges and concentrate on the local forces. They key risk that local investors who buy long-dated term deposits or bank shares face is that inflation rises sharply as a result of the mining boom and interest rates follow suit.

A large number of Australian DIY funds and private investors have been squirrelling away their capital in cash accounts and short-term deposits believing the forecasts of higher interest rates in the future. Bill Evans’ forecast of significant falls in interest rates may be overstating the position but the possibility of rates staying steady will still affect the returns from the interest-bearing section of your portfolio as rates for longer-dated commitments rise.

At the moment bank deposits of up to $1 million have the benefit of a government guarantee, but that is likely to be reduced possibly to $250,000 or even $100,000. Banks in Australia are very secure even without the government guarantee, but the guarantee certainly adds an extra dimension of safety and comfort that cannot be underestimated.

It is always well worth remembering that for longer-term bank deposits involving substantial sums banks will often increase their quoted interest rate by 0.1% or even more. Last night I did a ring around to see where Eureka Report readers could get the best rates for their money.

• For those seeking a one-year term deposit, there is not much choice among the big banks, with all four offering 6%; among the smaller banks Bank of Queensland has 6.25%, while Bendigo and Suncorp are offering 6.15%.
• For those seeking two-year deposit space, the ANZ is best value among the big banks at 6.2%; among the smaller banks you have the choice of Bank of Queensland with 6.35% or Bendigo Bank with 6.25%.
• For those seeking three-year deposits, among the majors there is not a great deal of difference to the two year rates, except the NAB joins the ANZ with 6.2%, Bank of Queensland offers 6.5% and Bendigo Bank 6.3%.
• For those seeking four-year terms, three banks stand out: St George, Bendigo and CUA, all offering 6.5%.
• For those seeking five-year terms, Westpac/St George and Bendigo Bank are standout performers with 6.8%.

For a long time now I have advocated that DIY funds and some private investors have an interest-bearing portfolio, and bank term deposits have been among the better performers. As you can see, right now there is a distinct premium for locking your money away for longer if you can afford to make that sacrifice.

When it comes to the sharemarket, I have asked my colleague Rachel Williamson to prepare a table to show the grossed up yields of bank shares. For those DIY funds in pension mode that can afford to take on the risk associated with bank shares, the benefits of franking combined with their tax-free status means that yields of up to 10% are possible.

-How they compare
	ASX	Close 20/7 ($)	12-month high ($)	12-month low ($)	P/E	Dividend yield (%)	Grossed up yield (%)
ANZ Banking Group	ANZ	20.78	25.96	20.45	9.98	6.51	9.3
Commonwealth Bank	CBA	48.55	55.77	47.45	12.33	6.09	8.7
National Australia Bank	NAB	23.67	28.18	23.29	10.8	6.67	9.5
Westpac Banking Corp	WBC	21.1	25.6	20.5	10.47	7.09	10.1
Suncorp Group	SUN	7.62	9.76	7.58	12.08	4.54	6.5
Bank of Queensland	BOQ	8.16	12.32	7.63	11.84	6.26	8.9
Bendigo Bank	BEN	8.59	10.45	8.3	10.87	6.81	9.7

Of course the greatest risk for these investors is knowing whether these dividends will fall.

When it seemed that interest rates were headed towards a 0.5–1% rise over the next year or so, the banks were in the front line for bad debt damage and the dividends looked shaky. These rises would have caused a large number of home owners to default on their mortgages and bad debts would have increased substantially.

At current levels of bank shares, the market appears to still be pricing in the strong possibility that bank profits could fall sharply if interest rates rise and take with them their dividends. Australian banks are still going to have bad debts but the amount of those bad debts will be considerably reduced if the Reserve Bank holds interest rates hold at current levels.

Of course Australian banks will not escape unscathed if we see pandemonium break out on an international scale, but remember that Australian banks are in much better shape than they were when the global financial crisis hit. Their overseas borrowings have been considerably reduced and they have issued longer-term loans so any short-term squeeze will be far less severe. The flow of cash from DIY funds into their vaults also bolsters their positions.

Footnote: The two banks that were most likely to be hardest hit by higher interest rates were Commonwealth Bank and Westpac. Commonwealth Bank purchased about $13 billion of debt that was originated from the US conglomerate GE group and its affiliates. Taking GE out of the market was a major achievement for Commonwealth Bank, but many of the debts purchased were suspect and would have been put under great pressure with more rate rises. CBA and Westpac were both aggressive lenders in the housing market at close to peak values. But while CBA and Westpac would be in the front line, all the banks would be affected adversely by higher rates.