As the Reserve Bank of Australia slashes its cash rate, savers and retirees are watching their incomes fall. While advocates of low rates are ubiquitous in the media, most of the complaints to the RBA are from the numerically larger savings population.
In October 2012 the average bank deposit rate was a touch under 3.5 per cent, which just covers the cost of living. Many investors are being forced to hunt for better yields. And with higher yield inevitably comes greater risk of loss and product complexity.
Australian Securities and Investments Commission chairman Greg Medcraft can see the emerging problems caused by low rates. It is an eerie echo of the time before the global financial crisis when the US Federal Reserve’s excessively loose monetary policy led investors to search out superior returns via byzantine products. Having been Société Générale’s head of securitisation in the US, Medcraft implicitly understands this territory.
Today I want to try to unify the universe of investment options available to you through the prism of a major bank. There are various ways you can earn money providing finance to the banks. Comparing this range of products is an elegant way to wrap your mind around the trade-off between risk and return.
Remember, a bank is made up of money it sources from shareholders (“equity”) and creditors. A bank’s business model is to raise capital as cheaply as possible and lend it back out at the highest interest rate. The gap between its cost of funding and what it earns is called the net interest margin.
When you put savings into a deposit, you are lending to the bank. Banks love deposits because they are the least expensive way to find funding. They also give the lowest returns. Indeed, transaction accounts typically pay a near-zero interest rate. The benefit, of course, is that deposits are safe, though not risk-free.
One oversight in our regulatory framework is that you are not told of bank (or government) credit risk when you lend to them. There is no good reason for this. History proves banks can fail, and governments can default. At the very least, deposit-takers should disclose the risks you assume when extending them credit.
Beyond deposits, we can supply funding to a bank by investing in their “bonds”, which is another type of loan, their “equity” (i.e. shares) or some mix of the two via Frankenstein-style “hybrids”.
The safest of all bank investments is a “covered bond”, which is secured by a specifically identified pool of assets. If the bank goes bust, you have recourse to these assets ahead of anyone, including depositors. In fact, the “AAA” covered bond rating is higher than the bank’s “AA-“ rating.
While covered bonds may have a five-year term, you can trade in and out of them every day. They are bought and sold in the liquid “wholesale” bond market, and settled via a platform called Austraclear, which the Australian Stock Exchange owns. And, like a variable or fixed-term deposit, you can get “floating” or fixed covered bonds.
A fixed covered bond pays the same coupon over its life. The variable option provides a predetermined margin above a variable benchmark that is reset every quarter. This benchmark broadly tracks the RBA’s cash rate, and is called the 90-day bank bill swap rate. It was around 3.2 per cent in October 2012, when CBA’s variable rate covered bond paid 3.9 per cent, slightly better than the average bank deposit.
Tthere has been a striking compression in the cost of bank bonds. When CBA issued its first covered bond in January 2012 it was required to pay investors a margin of 1.75 per cent above the bank bill rate. In October 2012 the same bond offers a margin of only 0.7 per cent. While incoming investors are receiving lower returns, the original ones made terrific capital gains through an increase in the bond’s price as CBA’s perceived risks declined. This highlights a distinction from normal deposits. Whereas bank deposits never get “revalued”, bonds are repriced every day based on investors’ assessments of the institution’s creditworthiness.
After covered bonds and deposits, the next safest major bank investment is a “senior-ranking” but unsecured bond, rated “AA-”. In October 2012 this paid a return of about 4.3 per cent, which was also better than the average deposit.
Like covered bonds, these senior bonds are not easy to access as they are traded in the wholesale market and require minimum investments of $500,000. Two ways to tap into them are through a managed fund that focuses on fixed income, or via a broker like FIIG, which breaks bonds up into smaller chunks.
In 2012, Westpac, ANZ Banking Group and National Australia Bank have listed on the ASX $4 billion worth of “subordinated bonds”, which rank behind senior creditors but ahead of everyone else. These are not to be confused with hybrids, which give banks the option of not paying you dividends, have ultra-long if not perpetual terms, and convert into equity under adverse scenarios. The new ASX subordinated bonds have fixed maturities and legally binding payment obligations. They currently offer interest rates around 6 per cent.
Hybrids and shares
The final two options are hybrids and straight equity. The term “hybrid” is confusing. The idea behind debt is that you are protected as a creditor when things go pear-shaped. You get paid out before others. In contrast, equity investments are the first to lose. Many hybrids seem safe but transform your cash into vanilla equity if the company is in trouble.
A fully franked major bank preference share, which is a hybrid, gives you a dividend of about 7 per cent. This sounds good until you compare it to the bank’s ordinary shares, which offer a franked dividend yield over 8 per cent with similar, albeit marginally greater, risk.
In practice, there should be a role for many of these investments when building a diversified portfolio.