Banks are the cornerstone of the Australian economy, but is there a better option for exposure?

When you think of the Big Four banks, what comes to mind? As a homeowner, mortgages are probably front and centre. As a shareholder, quality, dividends and strong balance sheets probably top the list. Even as many brokers raise concerns about valuations and suggest a sell on these stalwarts, the truth remains that Australian banks are considered high quality, even if the yield on equity is looking less attractive lately. 

There’s no reason to completely forgo exposure. The answer might be as simple as considering other areas of the capital stack. Traditionally, investors have found it hard to access the complete capital stack—the senior bonds, hybrid securities, and subordinated bonds—but these can be highly attractive exposures on a risk-adjusted basis.

Marc Jocum, Product and Investment Strategist for Global X ETFs, points out that using a combination of investments across the stack can offer diversification and better security, because of the seniority ranking in the event of a bank default.

“You’ve got this nice little layer up here where it actually protects investors from a capital preservation perspective, but you’re also getting access to relatively decent yields,” he says.

In this episode of The Pitch, Jocum discusses the capital structure of the banks and the types of yields each offers. He also discusses the Global X Australia Banking Credit ETF (ASX: BANK).

Please note this interview was recorded on Tuesday 3rd September 2024.

Edited transcript

Given so many people hold Aussie banks, why have you decided to create a product specifically around them?

Australian banks are the cornerstone of our economy. They make up a considerable size of the share market, but what we found was investors were only exposed to a certain level of exposure to the Australian banks being within banking shares.

There's a whole other side of the bank's capital stack or the capital structure, which just refers to the mix of debt and equity that a bank manages on its balance sheet and investors found it quite hard to get exposure to.

ETFs have made it very easy to get access to Australian fixed income, particularly within the banks. But what we found is that the banks are quite stable, they are very trusted, people are familiar with them. We wanted to introduce a product that gave Australians access to a fixed income security but had a decent level of trust and a decent level of credit quality as well.

When you look at the quality of Australian banks, they are some of the highest in the world. And overall Australian banks, whilst they may make up a considerable part of the share market, they still make up a very small part of the bond market. Aussie investors generally allocate around about 14-15% to fixed income, and that's quite low compared to our global peers who have 30- 40% in fixed income. And that 14- 15% has been the same for 10 years. By now introducing a product that has that access point, we hope to see that more Aussie investors start looking at Australian fixed income, particularly with banking credit.

The Aussie banks are facing a more challenging environment, and we usually discuss that in share prices. Does that matter in the world of banking debt?

When you think of banking debt, it's really important to monitor the credit risk of a particular institution because there is a risk that the bank could default or not pay their security. The good thing about Australian banks is that they are rated very highly by credit rating agencies, but you've got share market volatility and that there might not be a known outcome when it comes to the share price of an actual underlying company.

Bank credit is a little bit different because normally you could expect as long as the bank doesn't default, the yield to maturity on a bond is what you're generally going to be expected to get if you hold it towards the end. 

The great thing about a product like bank credit is once that does mature, you don't have to worry about finding the next product to invest in. You can actually roll into whatever the index methodology is.

I think overall it is important for investors to monitor the credit quality of banks. A lot of people at the moment are a little bit nervous around, “well if we go into a default cycle, what does this mean for the Australian banks?”

They are extremely strong and if you look at the non-performing loans or the level of mortgage arrears that are above 90 days, it's still very low like sub one. Overall Australian banks have been very well positioned since the GFC. They've also had to maintain a high level of capital within their balance sheet to make sure that they can meet any unforeseen circumstances. So, you've got a sufficient amount of regulatory capital, a pretty liquid instrument overall. It really does paint the picture for Aussie investors seeking a trusted source of income, but also to not go too far out on the risk curve. That's where we see Australian banking credit being quite attractive.

When you talk about accessing Australian banking debt through the new BANK ETF, what does that mean?

Banking credit encompasses the broad capital structure of a bank. You're talking about both the mix of debt and equity, and when you think about the capital structure, you've got multiple layers and each layer acts as a line of defence to protect depositors and senior creditors.

Right at the bottom is where shares sit, right? And that means that if the bank were to ever liquidate or there was an unforeseen circumstance, shareholders would be the last to get in line to get their money back. Whereas you've got the entire capital structure and it's pretty much ranked in terms of seniority.

You've got senior bonds towards the top, then you come below and you've got your subordinated bonds, your hybrid securities, and then the shares. So you've got this nice little layer up here where it actually protects investors from a capital preservation perspective, but you're also getting access to relatively decent yields and you can combine both your general fixed income securities like senior bonds or subordinated bonds with something like a hybrid security, which has a mixture of both debt and equity like instruments.

You can benefit by getting a wide range of different income profiles through out there. It’s a really good source and a really good access point because traditionally accessing banking credit was tough, not just that if you wanted to get each sleeve within the capital stack, there was only one ETF for each one. Now we've come to market with an ETF that has three layers within the capital stack of a bank providing multiple sources of income. And especially now because banks want to keep increasing their regulatory capital, it's likely bonds will need to issue more bonds or at least not go to the equity market if they don't want to dilute their existing shareholders. We could expect to see more issuance coming to market and that's a great outcome for investors looking to get access to this security.

What are the three layers that you invest in for the fund?

We’ll start with senior bonds.

These are the bonds that rank the highest in terms of seniority. Generally because they rank higher, their yield profile won’t be as much. Most of them tend to be fixed rate rather than floating rate notes. They do carry that interest rate risk as well.

Then we go one layer down towards subordinated debt.

This is also known as Tier-Two capital. They rank a bit more junior compared to senior bonds and they do have different features compared to senior bonds. Because they are more junior, or subordinate as the names suggests, you are getting compensated by getting a high yield in some of these securities. 

They are paying relatively nice yields at the moment compared to what you may get in government bonds or term deposits at the moment. And, not just that, you’ve also got a layer below subordinated debt, generally floating rate. A lot of people have been getting into subordinated debt to protect them from interest rate rises.

Then we go one layer below and this is what is known as hybrid securities or additional Tier One capital.

Hybrids is a bit of a unique asset because it combines both elements of equity and fixed income.

On the fixed income side, it's similar to a traditional bond because it pays a fixed level of interest, whether it be on a regular cycle, but then it's also got this equity-like feature where they are a little bit riskier than traditional bonds, but under certain events they could actually convert from being a fixed income security into an equity. So, it converts into a share.

Now, because there's that risk involved, you do get compensated by getting normally a high yield profile. Hybrid spreads are normally around about 300-350 basis points above the normal risk-free rate, but at the moment, they are close at about 230. They may be seen as expensive, but they're still very important part of the portfolio because they do have those franking credit benefits as well.

Those are the three layers that the BANK ETF invests in. It’s a really nice diversified approach and has a 40% weight to senior bonds, 30% to subordinated and 30% to hybrids, or follows an index based methodology under the ETF wrapper, which makes it a liquid and transparent way to access banking credit.

The portfolio also uses 80% floating rate instruments over fixed. Why is this?

That's just the nature of the rule, right?

So, the rule with the portfolio is that you've got that 40/30/30 split and traditionally, because your subordinated bonds and the hybrids technically don't have that fixed rate exposure, naturally, most of it's going to be into floating rate notes. It might not be such a bad thing to be positioned into floating rates at the moment. However, if interest rates do fall naturally, the floating rates will probably reduce as well, which is why having a little bit of duration in the portfolio from the fixed rate component could actually add a layer of protection for your portfolio overall.

It's kind of nice to have this. I don’t know that I’d want to be 100% fixed or 100% floating. Most people, based on what we've seen in ETF flows, have been gravitating towards floating rate notes and that was kind of the push for wanting a product like this. You're getting access to multiple securities, different payment structures, different maturity dates, but naturally at the moment the product's going to have 80% weighting to floating and a 20% to fixed rate notes.

How can investors use an exposure to Australian banking debt in their portfolio?

It definitely fits within the defensive sleeve of client's portfolio. It really fits that core fixed income pillar because a lot of Australian investors may have exposure to government bonds and government bonds make up the vast majority of the multi-trillion dollar Australian bond market. Banking credit is only about 15% of the total bond market. Australian investors may be missing out on this really great opportunity that is within banking credit where it fits in the portfolio.

It definitely fits within the Australian fixed income sleeve because it doesn't hold any global fixed income securities. And that's where people can debate how much do I want in Australian government bonds and how much do I want associated to corporate bonds? But the great thing about this is instead of deciding which corporate bonds do I want to be in, which type of instrument, whether it's floating or fixed, which seniority do I want be in, whether it's senior subordinated or hybrids, this does everything for you in one package.

It is a really convenient access wrapper at a very low cost. We are charging 0.25% per year, a lot lower than what you may get with traditional active fixed income managers providing a diverse source to multiple different securities. There's over a hundred securities in the portfolio across eight different issuers, and you're getting that nice exposure across multiple banks, not just one bank. So, you're reducing that idiosyncratic risk as well.

Again, it’s a really great product to provide access to Australian investors that they didn't really couldn't access before. There were high minimum investment amounts, and it wasn't easily accessible. The ETF has done that for us, and it's great that we can offer that to clients who are interested in achieving an income-orientated portfolio across a diverse set of banking securities.

Learn more

BANK is the only index based ETF offering exposure to the broader capital stack of Australia’s banks in one diversified solution. BANK expects to pay monthly income and its index has historically offered higher yields than term deposits, government bonds and corporate bonds.

ETF

Global X Australian Bank Credit ETF (BANK)

Australian Fixed Income

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