Australia’s bank shareholders, including those holding Commonwealth Bank of Australia and National Australia Bank are wondering how their bank shares might be affected by the current sell-off and uncertainty in credit markets.
I received quite a few emails from our Rask Invest members asking me how low-interest rates and the economic downturn could affect banking profitability, as well as the implications for insurers such as Insurance Australia Group) and Suncorp Group.
Take it from me, the short answer is no analyst can tell you exactly what comes next for the Australian banks. However, there are a few things that are now more likely than before the crisis.
Dividends will be cut.
Dividends will be cut, for a multitude of reasons. The historical or trailing dividend yields currently shown in your brokerage account for CBA, ANZ, Westpac and NAB shares is a mirage. With some banks now offering up to six months of no repayments to mortgage holders, cash flow will dry up very quickly.
Admittedly, the banks will try and get what they can from Government coffers during the downturn, as they did during the GFC.
However, if you ask me, the banks have been wanting to cut dividends for years, so they can retain more of their capital to fund future growth plans. Depending on how you look at it, cutting dividends now might actually be a good thing for the banks in the long run. Nonetheless, a drop in dividend income will hurt.
Bad debts will spike.
Despite Government stimulus and the banks’ best efforts, it seems likely that thousands of Australian households will go overdue on their loans. Bad debts across most Australian banks have fallen to near-record lows in recent years. It’ll be a long time before we see that again.
From an accounting perspective, when a bank incurs bad debts they are taken straight from the income statement. Meaning, they directly cut into reported profit. As you can imagine, this reduction in profit loops back into potential dividend payments, since many of Australia’s banks pay dividends based on the percentage of their reported profit.
In my opinion, rising bad debts and high unemployment numbers are a medium (2-3 years) to long run (5+ years) implication for the banks and their shareholders. Although it’s somewhat different this time around, long-running NAB shareholders will remember that it took the bank well over five years to rid itself of the bad loans incurred during the GFC. That’s a reason why NAB underperformed other bank shares.
Lower profits, for longer.
In a low-interest-rate environment, Australia’s banks have found it very hard to maintain their profitability. You can see this in the net interest margins or NIMs reported by the banks since the GFC. Now with even lower rates, I wouldn’t be surprised to see lending margins stay below 2 per cent for a very long time.
Outside of lending, there is little reprieve. Following the banking Royal Commission, Australia’s banks no longer have their financial advice and funds management businesses to deflect some of the pain in lending.
Hybrids will convert.
According to NAB’s ASX update last week, the bank has already started converting certain hybrid investments into ordinary shares:
Source: NAB ASX presentation, March 2020.
Investors who had purchased these hybrids on the assumption (or advice!) that they were safer than normal shares are now feeling the pinch of being sold into a product that was too complex for normal investors to understand.
The conversion means existing shareholders are diluted (because there are more shares available). Also, it will likely put further pressure on the share price in the short term. And the hybrid investors are no longer likely to receive the same level of dividend repayments as they would have with a hybrid.
Right now I don’t believe Australia’s bank will go bust in the current market crash and the likely credit squeeze we’re about to experience. Australia would throw everything at the banks before they let one of them fail.
However, please note that even if the Government did bail them out, they would (or should) demand their pound of flesh in the form of equity or debt.
The bottom line for investors is that I do not believe it’s worth buying into CBA and NAB shares for dividends right now. I’d consider buying at much lower prices and probably in 6 months from today, once the dust has settled. The near-term uncertainty and questions over their long-term profitability concern me.
However, I might consider owning a low-cost and diversified dividend ETF or a simple market cap ETF. At least with a diversified ETF, investors are not dependent on fully franked dividend income from just one sector: banking.
Disclaimer: this article contains general information/advice only. It is not personal financial advice and it is not a substitute for advice from a licensed and trusted financial planner. The information does not take into account your needs, goals or objectives. Owen does not own a financial or commercial interest in any of the companies mentioned.