Banks' battle zone will crimp yields

PORTFOLIO POINT: Macquarie Bank and YBR are making a fierce play against the other majors for new loans business. Lock in longer-term deposits and search out other interest-bearing alternatives.

Low interest rates are here to stay for now and, if you’re relying on income from bank term deposits and other interest-bearing securities, get ready for some more yield pain.

This week I want introduce you to some dramatic early-date events taking place in the banking industry, which will influence your long-term interest rate investment strategies including term deposits, mortgage loans and perhaps, longer term, bank shares.

You remember that last week I looked at the various term deposit rates that were available from banks. What I didn’t discuss was the length of term investors should take, except to say that I expected interest rates to fall, so obviously longer term deposits were a better proposition unless the money was required for other purposes.

But now more dramatic events are taking place that underline the need for a higher proportion of longer currency term deposits.

The Australian banks have had virtually a closed shop when it comes to the housing market in Australia. CBA, Westpac, ANZ and NAB dominate the field, either directly or through their subsidiary banks.

But now there is an important development. Macquarie Bank has a large pool of cash management trust money, often obtained via financial planners who use Macquarie as a parking place for money as it moves through their systems.

This is low-cost money and it effectively reduces in cost each time there is a reduction in interest rates.

For a long time Macquarie has used this money to fund various ventures in investment banking and other activities. But more recently investment banking has not been a good profit earner, so it has wound it back. And Macquarie is now directing a substantial amount of that cash to the Yellow Brick Road Company operated by Mark Bouris, who developed the Wizard business and sold it to GE for around $500 million.

Bouris has a network of about 150 branches around Australia, but more importantly through his television arrangement with the Nine Network has access to substantial free or low-cost advertising. Bouris is cutting the interest rates on housing mortgages by about 0.3% below the majors and promoting this on the Nine Network. (He proudly announced he was passing on the full rate reduction, but in fact the real housing rates are a series of reductions from the standard). Never before has a bank rival upstart had such access to low-cost promotion (Nine own a stake in YBR). The whole exercise is working way beyond expectations and Yellow Brick Road is being besieged with applicants.

But, of course, Bouris is starting from a small base and at the current rate he would have written about $6 billion worth of business in a year. That’s not a lot in overall terms (the Commonwealth has over $400 billion worth of mortgage loans), but Bouris is now going to double his branch network and is likely to be writing business two and even three-times current levels going forward. At this stage the smaller banks, including big four subsidiaries like St George, Bank of Melbourne, Bank SA, Bendigo Bank etc, tend to match any Yellow Brick Road offerings to customers that come to them. But the other banks, particularly CBA and Westpac, tend not to match and so a great deal of YBR business is coming from them.

At this stage the amount of business that Yellow Brick Road is writing is not going to change the world, but the CBA in particular seems to be very sensitive about this matter and there have been angry exchanges with the Nine Network. Down the track the pressure from YBR is likely to quicken, particularly as mortgage borrowers realise that there is no particular need for them to pay the current rates when they can get a 0.3% reduction any time they like. (Tell those you know who have mortgages). Eventually, as momentum develops, the big banks will match Yellow Brick Road on a regular basis, but that is very costly if the lower rates are spread over the bank mortgage portfolio.

And the combined Macquarie and Bouris have room to cut even further if a war breaks out. In my view the big four Australian banks, and particularly CBA and Westpac, will not want to lose profitability. So, in time, this development is likely to put further pressure on their term deposits rates. In that situation it is advisable to take longer-term deposits and, of course, as we all know interest rates are falling and are going to fall further. The combination of the two means that you should be looking at three, four or five-year interest rates with that section of your portfolio. Of course, if you are going to need the money in the meantime, you must of course take shorter-term deposits.

These are early days, and I don’t believe the market fully understands the threat, but during 2013 they will gain a greater appreciation of what is happening. This will not affect banking profits in the current year, or even next year, but longer term the growth in banking profits, which was looking to be stunted, is likely to be even more stunted. I am not forecasting dividend rate reductions, but we all should be aware of what is taking place.

I also want to discuss in more detail other fixed-interest investments.

Hybrids have been a very popular investment for self-managed funds, but they have two very clear drawbacks. First, the rates paid by them decline as interest rates decline. And, second, they really don’t have any great security and rank after unsecured creditors, except that if their distributions are not being paid then there can be no dividends for shareholders. Australian banks are well capitalised, with strong profitability, and I don’t think there is a great risk of this taking place. Accordingly, I have investments in hybrids spread between the majors.

But I am nervous about most of the other hybrid securities. In particular, I am not keen about insurance company hybrids. Insurance companies have hybrid securities as equity because they are vulnerable to major climatic and other disasters. If the global warming people are right, then the rate of disasters is likely to increase. Now, of course, insurance companies reinsure, but returns in the insurance business are declining because of the low interest rates, so it is always possible that a succession of disasters could cause great problems in global insurance.

With any interest-bearing security, the important feature is to make sure that your principal is safe because you don’t have access to the upside of the equity.

A number of people are now investing in corporate securities that are available through brokers. I certainly have done that. In each case I like to look behind the security to the revenue model. If the security is a property, then who is the tenant? And will the tenant still be there when my money is due and payable? If it is a trading business, what is the share price? And what is their profitability situation? As yields on bank term deposits fall we are going to need to go to more corporate securities to get higher rates, so that test of the ability of the people borrowing to repay the loan becomes more and more important.

There are other interest-bearing securities on regular offer. For the most part I don’t think they are worth the risk unless you are very certain of the management and funding base of the company you are investing in. I have some deposits with the RACV Finance Company. The parent body is Australia’s largest mutual and doesn’t have any gearing, and the money is spread over a vast number of vehicle financing, so I feel perfectly safe in that situation.

What about solicitor mortgages? I have some. The particular firm I deal with has been in the mortgage business for around 70 years and I have a series of relatively small amounts in particular securities with mortgages over particular properties. I have not had one accident, although there have been a couple of forced sales because people couldn’t keep up the payments. I don’t particularly like pooled situations because depositors may withdraw. I like to have a particular security and have a number of them as a spread. Providing the solicitors do the work and make sure that every mortgage is well covered with property values, you are relatively safe unless there is a very sharp fall in the housing market. In some ways I am breaking my own rules, but I have supreme confidence in the integrity of the solicitor’s firm.

But, as a general rule, unless you know what you are investing in and are very clear what the proposition is, the higher the rate the greater the risk. And so, if somebody is borrowing money at say 1 or 2% above bank term deposit rates, then clearly they have to on-lend and are taking a higher risk than banks would allow. The great problem with finance companies is that bank lending takes the best of the projects, and that leaves the more dangerous loans to the various finance companies that are in business. I just don’t think it is worth the risk. And we have seen with Banksia, and a few others, just how much trouble they can get into because they have been lending to second-rank borrowers.

Life for interest-bearing securities investors is going to be tougher than it has been, so make sure your principal is safe as you can make it. It is better to take a lower rate than take a substantial risk, and finally understand there are difficulties in the banking market that are going to get more acute as the Macquarie/Yellow Brick Road invasions develops momentum.

This article is the latest in our series The Yield Chase. To read other articles in this series, click on the story links below.

Running out of dividend steam?

Fixing for a high yield fix

Taking a defensive yield tack

Cashing in on term deposits

Shopping for yield in Woolies’ property float

Telstra’s high-speed yield connection

Trustees seek yield safety

Yield spotlight shines on REITs

Hunting in US property