Summary: The major Australian banks have been keenly sought after as yield plays, but they are starting to look overvalued and there is some room for profit taking.
Key take-out: Ordinary shares may pay the highest yield, but for diversified investors who want to protect their portfolio, it is also about downside risk. Securities such as hybrids and listed bonds offer an alternative investment that will suffer less volatility than ordinary shares.
Key beneficiaries: General investors. Category: Shares.
The big four banks are “yield play” favourites as they traditionally pay franked dividend yields above the market average (the average dividend yield for banks is 7.34% versus the S&P/ASX 300 index average of 5.27%).
The banks have done extremely well as the interest rate cycle bottoms – with strong annual price returns and dividend yields (see figures1 and 2 below).
The Australian banking sector has been labelled the most profitable in the developed world – based on pre-tax profits as a percentage of total assets, as well as wider net-interest margins and low costs - just above the US banks, with Canadian and Swedish banks the next-most profitable.
If you like the banks and see them as good long-term investments, but are maybe feeling a little concerned about the rally in share prices in the last few years, there are other listed securities that have been issued by the banks in addition to their shares – such as bonds (subordinated debt and senior debt) and preference shares (also known as hybrid securities).
In table one below are all the securities issued by the banks and listed on the ASX. The securities offer an alternative investment to banks’ ordinary shares, and can be bought and sold in the same way as ordinary shares, with no minimum order required.
The columns of the table show the dividend yield or running yield. This is quoted as a gross yield where it is applicable for ordinary shares and preference shares, but the distributions of subordinated debt or senior debt do not include franking credits as they are considered interest payments. The yield to maturity or call (the first date a security may be redeemed) is also quoted as a gross yield where it is appropriate – and represents the investment in the security if it is held to maturity and there is a return of the face value of the investment. The risk of the security is how the security would rank with respect to repayment of the investors’ capital in the event of an issuer becoming insolvent.
Impact of rising rates
When the interest rate cycle reverses and interest rates start to rise, dividend-paying banks may not do as well as there will be other competing “yield plays”. Some of the strong price returns from the banks may revert. Additional options that could be considered as alternative sources of yield, and that are not as likely to suffer the same volatility as shares, are the other listed bank securities.
But it is also important to remember the difficulty of market timing an interest rate rise. The US experience has seen10-year US Treasury bonds gaining this year (yields falling), despite market forecasters expecting the opposite and after US bond prices actually fell, which meant lower yields for most of 2013. This highlights the importance of holding a diversified portfolio, which could be exposed to bonds as well as shares.
Figure three shows the strong contribution from the highest yielding companies, the major banks, Telstra and BHP, to the performance of the S&P ASX 300 Index in the financial year ending June 30, 2014. But whether the future performance of the high yielding shares can replicate historical performance remains uncertain.
The major banks look attractive based on their underlying businesses, but currently the only bank that is showing value according to Eureka Report’s valuations is ANZ ANZ (see ANZ’s compelling story). The other banks have over-shot what we consider good value.
Other listed securities issued by the banks
Hybrids or preference shares
In some previous Eureka Report articles hybrid securities have been discussed in detail (see Hybrids: higher yielding, but know the risks and Higher-risk hybrids on the rise) and the focus has rightly been predominantly about the risk an investor is taking on with a hybrid investment. Putting the ‘risk’ in perspective, the likelihood of a bank catastrophe in Australia is quite low. If there were such as an event, the hybrids would be a higher-risk investment – but the broad sharemarket itself would also be subjected to downside risk. Still, the presence of the strong regulatory environment in Australia and high levels of shareholders’ funds underpin the banking industry.
The performance of hybrids in a typical correction would be more correlated with the performance of the underlying share price – but the hybrids are generally less volatile than shares (the long-term volatility of hybrids is half that of shares). The lesson learnt during the GFC was that hybrids are not actually fixed interest securities. But during non-crisis times, hybrids do tend to display more characteristics of fixed interest securities due to their attractive, regular income stream with less share price volatility.
The yields from hybrids compared to the underlying issuers’ shares are invariably lower, but when compared to the term deposits paid by the banks, they are more attractive. The risk of any security depends on where the security sits in the capital structure, with respect to a winding up of the company. Hybrids are higher in the capital structure relative to shares, so the risk is lower than the risk of shares. Term deposits sit at the top the capital structure, so they are almost risk free (up to $250,000 guaranteed by the Australian government). Lower risk usually equates with lower return, and as you can see in Table 1 most of the hybrids (preference shares) are yielding a lower dividend yield (grossed up) relative to the ordinary shares.
One of the major concerns about hybrids is that if Tier 1 capital breaches the capital trigger of 5.125% the security will convert to shares or at the discretion of Australian Prudential Regulatory Association (APRA) if determined to be non-viable. APRA recently noted that among the risks that are associated with various hybrids are long terms to maturity, payment of coupons is discretionary, the market price of the security may fall, and that the securities are ranked below other debt in the capital structure of the issuer
But if you are happy to own the shares based on their underlying business, a hybrid investment could be an alternative option. Any market correction will impact both hybrids and shares – but due to the lower volatility of hybrids relative to shares the magnitude of the downturn will probably be lower for hybrids.
Subordinated unsecured debt (bonds)
Subordinated debt securities such as that issued by ANZ (ASX code: ANZHA) have a secondary or lesser claim to bank’s assets in the event of insolvency, than more senior debt or term deposits. Subordinated debt ranks above hybrids (in the case of ANZ, ANZPA, ANZPC, ANZPD and ANZPE) and ordinary shares (see Table 2 for a comparison of the characteristics of different types of ANZ listed securities). Hybrids are more widely held than subordinated debt issues, although these securities can be bought in the same way as hybrids.
Subordinated debt is further down the capital structure relative to term deposits or senior debt, but it is still debt with a fixed maturity date and non-discretionary interest payment obligations (so they cannot miss paying distributions like hybrids or shares). If the issuer were to become insolvent, the interests of the subordinated-debt holders will rank behind the senior secured and unsecured debt holders. Companies often issue subordinated debt as it can provide some support to the corporate credit rating assigned by ratings agencies such as Standard and Poor’s, Moody’s or Fitch Ratings.
Senior debt (bonds)
Senior debt ranks just under term deposits – is higher risk than term deposits but is lower risk than subordinated debt. CBA’s senior debt listed on the ASX (CBAHA) ranks above CBA’s hybrids (CBAPA and CBAPC) and as a result of being less risky is paying a lower yield than the hybrids.
An investor in CBA’s ordinary shares, earning a gross dividend yield of 6.72%, may query the reason for investing in CBA’s listed senior debt security paying only 3.65%. According to Eureka Report’s recommendation CBA is overvalued , with more than 13% downside risk to the price (see CBA’s price pressure point). So if there was a correction in CBA’s share price, the total return would fall, with the price correction offsetting some of the return from the dividend yield. The volatility of debt securities or bonds is about a quarter of that of shares, so owing a debt security like CBAHA, can provide some protection in a diversified portfolio to the downside volatility of the sharemarket.
The lower relative risk of senior debt securities is supported by interest payments being non-deferrable, cumulative, fixed maturity date, maturing for cash and cannot be converted to shares. So an investor knows what the outcome will be with respect to yield and return of face value if held to maturity, and there is less likely to be any unwelcome events over the term of the investment.
This does not mean that the issuer cannot default – in the event of interest not being paid, and the trustee can call for all funds to become due and payable by the issuer.
Market timing with respect to the bottom of the interest rate cycle is unlikely to be correctly predicted and acted upon by most investors – even the professionals cannot get it right. But that does not mean a portfolio cannot be prepared for downside risk and reduce exposure to unnecessary volatility.
As discussed, bank shares have provided some great returns to investors and the strong dividend yields will most likely continue. But the heightened risk of a fall in share prices is growing as many of the banks are starting to look overvalued or close to fair value. The dividend return may be attractive but that can be negated by a market correction of bank share prices.
Due to my concern that there may be a correction in bank share prices, it may be time to take some profits. Ordinary shares may pay the highest yield, but for diversified investors who want to protect their portfolio, it is also about downside risk, and securities such as hybrids and listed bonds (subordinated debt and senior debt) offer an alternative investment that will suffer less volatility than ordinary shares.