Is now the time to switch out your bank stocks?

Australian banks are investor staples, and with good cause. They’ve offered attractive dividends in the past and have solid balance sheets. But, with valuations looking stretched, perhaps it’s time to consider alternative exposures.

Marc Jocum, Product and Investment Strategist for Global X ETFs, sees plenty of value in holding bank exposures – but argues that Australians are missing a highly attractive form of exposure: bank debt.

He notes that bank debt is complementary to holding equity, but offers income investors a more defensive investment.

“From a capital perspective, Australian banks are market leading in the world, when you are looking at their capital ratios, their level of risk – they really are the envy of the industry,” Jocum says.

When you consider the current environment and the interest rate cycle change we are heading into, bank debt holds additional appeal, argues Jocum. 

In this episode of The Pitch, he discusses the Australian market and how banks are positioned, why investors should consider exposure to bank debt, and where it sits in a portfolio.

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

Edited transcript:

What is your assessment of the market today, and in light of that, how do you see Australian banks positioned?

We’ve just come out of August reporting season where a lot of the companies were in line with expectations. There were probably a few more misses than there were beats overall, but you still had some of the Australian banks reporting really solid earnings.

They are growing their loan books, albeit not as much as they were historically, but still growing. They are growing their deposit books as well. You’ve got the bellwether Commonwealth Bank of Australia (ASX: CBA), the most valuable company in Australia with $10 billion in profit and record dividends.

So even during a period of high interest rates and the consumer potentially weakening, the banks are still producing relatively good earnings overall. That being said, they are now trading towards their upper end in terms of valuations, and it’ll be interesting to see what happens if we do get a harder landing, if there is more of a default cycle, if consumption isn’t as strong, what happens with inflation getting back to the 2-3% RBA target? That will be really interesting. So, we do need to monitor what is happening with the banks overall.

Going forward, there is still promise within the banks. Most of the returns have been driven by dividends rather than the capital side. But overall, the environment still seems to be quite favourable for Australian banks overall.

The big four banks have been a staple of Australian investors for many, many years now, how do you convince investors to think about a bank credit ETF after years of strong performance?

It's a really good question because a lot of Australians love the big banks. They are exposed to them, whether it's in their underlying shares, their superannuation portfolio, even just their general mortgage or their bank deposits. I think what's really interesting though is that most Australians only have access to the banks via equity. 

Equity is the only way that traditionally most people would invest in Australian banks, but there's the whole other side of the balance sheet around their debt and the amount of bonds that are available within the banks that they can get access to. 

And when you're trying to convince an Australian investor to choose one or the other, I think both have a role in the portfolio. But when you look at the equity risk premium or how much more attractive are shares than bonds at the moment, it's actually at one of its lowest levels in probably the last 10 to 15 years.

To me, that then says to investors, particularly income-focused investors, if I want to try and achieve a sustainable level of income, why am I accepting a skinnier yield profile for a high level of risk? And that's where I think banking credit could be a really interesting proposition for investors, not just from a diversification standpoint, but from a yield perspective because you can invest in CBA shares, but their yield is now below what you could get in a bank senior bond from CBA. So, investors really have to think about, well, if I'm targeting income and I'm also targeting to kind of stay ahead of inflation, what is a good area to be in? Like I said, over 50% of the returns have been driven by dividends overall in the Australian market. That's where a lot of banks have generated most of the returns. So as a good income source, banking credit is definitely a potential avenue there.

Is the Global X Bank ETF designed to be complementary or a replacement for the Australian bank exposure in an income investor’s portfolio?

Definitely complementary.

I think that both are separate assets in terms of their actual characteristics.

One is a growth asset being the equity sleeve, but then you've got the defensive sleeve. A lot of people who were interested in the defensive sleeve were generally in term deposits, or just invested in general cash or government bonds.

Banking credit as a whole only makes up around 15-20% of the overall bond market in Australia so Australians don’t really have access to this diversified area. They could access the individual parts of banking credit, whether it be senior fixed rate bonds, whether it be subordinated debt, whether it be hybrid securities. But now, the Global X Australia Banking Credit ETF (ASX: BANK) encompasses all three different securities into one easy, low-cost, diversified package.

Overall we think it’s a really good value proposition for clients, particularly in this environment. Interest rates are seeming to stay a bit higher here in Australia, government bonds have already priced in a potential cut coming.

From a yield perspective, and also for diversification to trusted sources of income, what we are hearing from clients is that they want good sources of income from reputable organisations. And what’s more reputable than these? From a capital perspective, Australian banks are market leading in the world, when you are looking at their capital ratios, their level of risk – they really are the envy of the industry.

What are some of the other benefits of using this product compared to other income exposures?

I think one of the best value propositions of a product like this is the diversification aspect. You’re getting two layers of diversification with a product like this.

The first is around both growth and defensive split.

Correlations have been relatively positive over the last couple of years between bonds and shares. We have seen a little bit of a fall in correlations overall, back to I guess what people would deem as a bit more normal. But overall, you can get the second layer of diversification, which is within fixed income as well. It's great to have your fixed income and growth assets, having that diversification mix. But then within fixed income, you've got exposure to three different securities that all dance to their own tune. So, you're getting two layers of diversification within one product, which I think is great because diversification is one of the only free lunches in investing.

And then, secondly, is around the yield profile.

Historically and at the moment, yields have been relatively compressed over the last couple of years, particularly as you've seen bond yields rise. But now, with pricing in interest rate cuts, they've declined. In Australian share markets, yield has declined, banking share yields have declined. But, an area that's staying quite sticky is this area of banking credit. For Australians who used to get exposure to high dividend-yielding shares, they can now explore this idea of fixed income in a diversified way while still maintaining a decent level of income overall.

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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.

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Global X Australian Bank Credit ETF (BANK)

Australian Fixed Income

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