Bank Bonds Versus Shares - Will The Banks Grow In 2017?

But can we count on them to continue delivering, or is it time to look at other forms of exposure to the sector?

In terms of companies listed on the ASX, Commonwealth Bank, to my mind, is the lowest risk. The other three majors, Westpac, NAB and ANZ, are also low risk propositions for a number of reasons: they are tightly regulated by the Australian Prudential Regulation Authority, which elevates them above other corporations on the risk scale; the government guarantees deposits of up to $250,000 per entity without any charge, meaning in the worst case scenario many creditors are protected; they operate in an oligopoly; and, they are critical to the financial health of the country.

So what are the risks of investing in bank shares? Like any equity investment, bank returns are generated from a combination of dividends and share price.

The question for investors right now is whether they can continue to grow their franchises in a low interest rate environment awash with cash where there is fierce competition for new business.

While the greatest risk is that a bank can’t pay its debts and goes into a wind up, it is extremely remote. The more likely threat is to earnings with the potential for rising bad and doubtful debts in a slowing economy that could see a decline in dividends and share price rerating.

If we consider a worst case scenario, we can use the GFC as a possible predictor. In the CBA’s case, the value of its shares fell roughly 60 percent during the GFC.

Over the last year, CBA shares are down circa 13.5 percent from $86.76 to $75.07 on 22 June. The loss is reduced if you add back dividends and franking. All of the three other banks’ share prices also lost value, with ANZ and NAB down around 25 per cent. This sort of performance indicates growing concern over future earnings.

If you share these concerns, but still like the idea of having exposure to the banks, it may be worth considering bonds.

All the major banks issue a wide range of bonds in domestic markets as well as in foreign currencies. The drivers for investment are different to shares as bonds are a legal obligation and the bank cannot cut or forgo interest and it has to pay the face value of the bonds, usually $100, back at maturity. Bond investors are less concerned with growth; their main concern is that the company can make the payments when due. I like to say the main factor to consider when investing in bonds is the “survivability” of the bank or company.

I think it’s easy to say that all four major banks will survive in the long term – just like the shares, the bonds have the same benefits. But they have the added protection of shareholders that must absorb losses before they will lose any money.

Because bonds are lower risk they should have lower returns, but this isn’t always the case, as the last year demonstrates. Investing in a senior or subordinated bank bond will earn you between 3.0 and 4.4 percent per annum, which is the rate of interest on offer. Like shares, bonds are tradeable, you can sell them prior to maturity and the price moves up and down, so you can achieve higher than expected returns if the price of the bond rises.

If the price of the bond drops, because a bond will pay $100 face value at maturity, you have that as a backup and if you do nothing a bond will naturally mature. An investment in an Australian bank or corporate bond, will earn a positive return if held to maturity.

While bonds are lower risk, they don’t offer franking, which is a major benefit of shares. But it’s easy to get caught up in franking, when it’s not the main determinant for investment. Shares are also more accessible as they are available on the ASX. Most bonds are traded in the over the counter market and you must find a dealer/broker in order to trade. Three bank bonds are available as XTBs but this is miniscule in terms of the overall market. Most of the big banks now offer direct bond investment but they require high minimum amounts and only make them available to wholesale investors.

There’s a time to own shares and a time to own bonds. Ongoing volatility will provide opportunities in both shares and bonds but if you are seeking long term capital and income certainty, bank bonds may be your preference in the current economic climate.