Sources of Bank Income

Asides from Interest Income or Spread (that is the difference between interest received on loans and interest given on deposits), banks earn income from:

1) Fee from advisory services, syndication of loans, providing letter of credit etc.

2) Selling third part products such as Life and General Insurance. In a competitive market, banks have to cross-sell to generate Income to cover rising operating costs. 

3) Other banking products such as EDC Machines, Products focused on NRIs and affluent segments, gold mohurs, credit cards etc.

4) Charges and Penal Costs - For obtaining a physical statement, for not maintaining average balance etc.

5) By fulfilling Traditional Banking Needs - Such as fees for getting a Demand Draft etc.

The major banks have issued a number of different types bonds that give investors both income and capital. Moran provided a snapshot of the bonds on offer.

1. Senior secured debt (covered bonds)

Covered bonds are backed by cash flows from mortgage securities. All four of the major banks have issued covered bonds over the past two years.

Following changes to legislation in 2012, banks are now required to allocate 8 per cent of their mortgage loan pool as security against any covered bonds they issue.

Moran says if any of the loans default, the bank is required to replenish the loan pool so it stays at 8 per cent. These bonds are rated AAA and are therefore a very low-risk investment.

Annual income: 4.85 per cent.

2. Term deposits

Term deposits are also a very low-risk investment. However, a bank is not required to repay term deposit holders should the bank collapse. However, the government's guarantee of term deposits with balances of up to $250,000 goes some way in alleviating those risks.

Annual income: 4.50 per cent for a minimum $20,000 over five years.

3. Senior debt

Senior debt is a form of corporate debt that has priority with respect to interest and principal over other classes of debt (except senior secured debt) and over all classes of equity by the same issuer.

A bank cannot defer its coupon payment to senior or subordinated debt holders.

Moran says senior debt bonds are also very low-risk bonds in Australia. Most senior debt is issued over a five-year period. This means that upon maturity of the bond, an investor will get back the capital as well as income over the past five years of that loan.

Annual income: 6.13 per cent.

4. Subordinated debt

Subordinated debt transactions rank below senior debt. If a bank becomes insolvent, subordinated debt is not paid until all senior debt and unsecured creditors are paid first.

Moran says these types of bonds tend to have a longer maturity profile and therefore there is greater insecurity, as anything can happen to a company before the loan matures.

Therefore, banks tend to pay more interest for their subordinated debt.

Annual income: 5.32 per cent.

5. Tier 1 hybrids

Hybrids are essentially a mix of debt and equity features. The major banks are large issuers of these types of securities.

Moran says these structures can be very complex and carry an array of risks. For example, companies issuing hybrids that are cumulative means that if a company misses out on paying a dividend, the dividend payment must be made at a later date.

However, when it comes to hybrid securities that are non-cumulative, if a company cannot pay its dividends, the payments are simply foregone.

Also, bank hybrids come under a non-viability clause. This means the chief bank regulator, the Australian Prudential Regulation Authority, does not have to disclose the conditions or terms that make a bank non-viable should it cease to operate - an event that is hardly going to happen, but is still a risk.

Annual income: 6.32 per cent.

6. Shares

Shares have the highest risk in the capital structure of the bank. This is because dividends are not necessarily guaranteed, and in the event of a wind-up, shareholders are the last group of investors to be repaid.

In other words, Moran says there is no guarantee of dividend payment or return of capital.

Investors are, of course, duly rewarded for these risks. And with dividends around the 7 to 8 per cent (including franking) mark, there is no doubt bank shares reign supreme when it comes to income.

Annual income: 5.64 per cent (without franking credits).

Source