Australian Bank dividend yields are unbelievably high. And not in a good way.

Don’t be fooled by the dividend yields that you might see for the major Australian banks. They are reflecting a rosy vision of the future that is far from certain, and in my view are a value trap.

Australian Bank Dividend Yields are not believable

 For those with superannuation investments (where Australian bank shares make up a large part of most funds), investments or a home loan, it is important to understand the fundamentals of the banking industry.

To me, there are three significant risks to an investment in banks :

  • Global pandemic smashes demand and consumer confidence
  • Supply-side problems in China mean indebted companies start going bankrupt, and contagion spreads 
  • Demand problems from global travel restrictions mean companies stop spending on capital expenditure  

I’ve explained the risks a few times in the last week with these outcomes and will no doubt do so again. So I won’t go into that again today.

What I want to deal with is even if none of the above occurs, then Australian banks still have another big hurdle to jump:  

If interest rates stay stuck at low levels, then profitability will be eroded

 Economics of lower interest rates

The general theory is the Reserve Bank of Australia wants to get more economic activity to decrease unemployment and lift inflation. By lowering the interest rate:

  • Consumers with home loans save money. For a small proportion, this means that they can afford higher house prices and so bid up the value of existing houses. For other consumers with home loans, the cost savings and the confidence from higher house prices translate into greater consumption spending.
  • It becomes cheaper for businesses to borrow to invest. The mix of more consumer spending and less expensive loans means that more firms invest.

The combination of the two is a virtuous circle that then employs more people, which creates more consumption and more business investment and so on.

However, these are reliant on the expectation:

  1. banks will lend more money as interest rates fall. 
  2. consumers will be confident enough to take out the loans
  3. businesses will be confident enough to take out loans and expand

Bank Business Model 

The problem is banks have different incentives in their business model: low-interest rates are not necessarily better. If interest rates are too low, it can be a disincentive for banks to lend. As we have seen in both Europe and Japan.

At the simplest level, banks are an asset/liability mismatch. In essence, banks borrow from depositors (and others) on a short term basis and lend it out for long periods.

So, banks make the most money when short term rates are low (borrowing is cheap) and long term rates are high (lending is expensive). This is called a steep yield curve. The actual level of interest is far less important than the difference between the two interest rates.

But, as many depositors know, banks stopped paying interest on most transaction accounts a few years ago. So banks can’t lower interest rates on those accounts any further to reduce costs. This means lower rates don’t decrease bank costs for at least part of a bank’s liabilities. 

The other part of a bank’s liabilities is more complicated. The short version of the story is yield curves are very “flat” (rather than the profitable steep curves), and so there isn’t much relief on that front either.  

The net effect: rates cuts for banks are going to eat into profitability.

Europe has been facing this conundrum for years. How do central banks keep rates low enough to stimulate the economy but not send the banks bankrupt?

And that is where Australia now finds itself. 

Investment Outcomes

The three main investment factors are that Australian banks:

  • Earn some of the highest returns on equity in the world
  • Are some of the most expensive banks in the world
  • Look attractive from a yield perspective as interest rates march lower

The optimists suggest:

  • You pay up for quality
  • After brushing off the Royal Commission, Australian banks are through the worst
  • The housing market is now rising in Sydney and Melbourne, reducing the chance of bad debts
  • Clearly, the government is ready to roll out more policies to support the housing market and grow credit quickly
  • Coronavirus will pass quickly, and the world will bounce back in a “V” shaped recovery.

The pessimists suggest:

  • As interest rates in Australia chase the rest of the world downward, returns will do the same
  • If returns fall any further, then dividends will be cut 
  • The housing market is vulnerable – the government and regulators used most of their bullets trying to hold house prices at high levels. Now that we have an external shock, the tools to support the market are limited.
  • There is still a rogue agency (ASIC) trying to litigate against the banks and actually enforce the Royal Commission findings. This could restrict credit once more.
  • Forward indicators of construction have cratered. And there is a gap in the infrastructure pipeline over the next few years. And the bushfire effect on tourism. And the coronavirus effect on almost everything. We saw in Western Australia over the last five years that rising unemployment trumps easy credit.
Perth Housing Crash vs Sydney/Melbourne Boom

Our View

In our superannuation and investment funds, we are very much erring on the side of caution.

First, I do think that at least one of the major risks is likely to occur. But, even if banks dodge all three, then the low interest rates forever are going to strangle bank returns. And Australian banks are still not cheap! Relative to other banks around the world, the Australian banks are some of the most expensive.

Make no mistake: right now, an investment in the banking sector is a macro-economic call. If you want to buy the banks on your expectation of a favourable macroeconomic outlook, then I can understand that view. But given all the risks, don’t get starry-eyed over a dividend yield that is far less certain than at any time in the past decade.

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Damien Klassen is Head of Investments at the Macrobusiness Fund, which is powered by Nucleus Wealth.

The information on this blog contains general information and does not take into account your personal objectives, financial situation or needs. Past performance is not an indication of future performance. Damien Klassen is an authorised representative of Nucleus Wealth Management, a Corporate Authorised Representative of Nucleus Advice Pty Ltd – AFSL 515796.

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Comments

  1. A crashing AUD could hurt the banks badly, if they have insufficient cover.
    Much of their liabilities are priced in USD while their assets are all in AUD.

    A falling AUD could cause the RBA to raise rates, which would crash property values. If forced to mark to market, the banks will then need to raise more capital.

    I expect the RBA to step in with a form of QE where they buy residential property to keep prices high.

    • And the banks have to roll over their offshore debt. The durations are short for the most part, a matter of months, so when funding costs spike because of defaults then their profitability evaporates and they risk becoming illiquid or even insolvent, even if they raise rates. Raising rates in the face of deep economic contraction will be the icing on Australia’s shit sandwich

  2. “How do central banks keep rates low enough to stimulate the economy but not send the banks bankrupt?”

    Perhaps it’s time to start having a conversation about the role of central banks here?

    Cutting rates from 5 to 4% to lift a lagging economy is fundamentally different to cutting the cash rate from 1% or pushing bonds negative. No business is going to fund projects that suddenly clear a hurdle rate a 1%, it would weaken their return ratios and they could beat that potential projects returns just by buying back their own shares, all at no risk and likely to earn management a bonus.

    Perhaps there needs a mandated fiscal response once rates fall below a certain level? I don’t know, but leaving growth and employment to some unelected dweebs that spank it to pictures of the Phillips curve seems like a really stupid idea.

    Anyway, agree with you on the banks. The whole market looks massively over valued to me, but that’s what happens when the cash rate gets trashed.

    What is a share in a company worth if rates are zero or negative?

  3. SoMPLSBoyMEMBER

    Good stuff DK!
    The banks are also very highly leveraged ( well above their customers) where ~ $70,000 of shareholder equity supports $1,000,000 in loans.
    If just 2.5 % of the loans fall down, there goes 35% of that equity!
    A little bit higher and they’re upside down and underwater.
    Credit ‘events’ ( and quarantine / lock downs) that could crash them happen fast too!

    • happy valleyMEMBER

      Is your leverage calculated on a risk-weighted asset basis (internally risk weighted by each bank and not by APRA?), because off memory the nominal leverage of banks is actually higher, being in the 20+ times range?

      Christopher Joye used to make this distinction until he seemed to become enamoured with the quality of Strayan bank management and with the income returns and capital gains prospects of bank hybrids (albeit if the SHTF, they would be first cab off the rank for bail-in).

  4. So correct me if I’m wrong but NAB at $22 dollars seems like a reasonable buy especially with a Govt Guarantee if the SHTF. 4 banks $250k each at about 6% with a guarantee I mean if I had a mill! ….how cheap can they go. GFC prices or lower?

    • Are you confusing the gov guarantee (on deposits) with the dividend yield (on shares)?