Banking on special dividends
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Nicholas Grove is a Morningstar journalist.
It is no surprise the big four banks constitute a large chunk of many income-focused equities portfolios, given their strong balance sheets, steady earnings growth, and high and sustainable dividends.
According to a recent CommSec survey, Westpac Banking Corporation (WBC), Australian and New Zealand Banking Group (ANZ), Commonwealth Bank of Australia (CBA) and National Australia Bank (NAB) occupied four of the top six portfolio holdings among all the broker's clients.
Also, the banks' dividend yields, which are roughly around the 6.5 to 7 per cent mark, currently compare to term deposit returns around the 5 per cent mark. And with interest rates on a downward trajectory, term deposit rates are looking a bit less appealing.
Many investors will also be aware of the upcoming implementation of the Basel III global banking regulations, which provide a global standard for capital adequacy among banks in a post-GFC world.
And with the big Australian banks comfortable with capital levels heading into this new regime, and given their strong generation of free cash flow, analysts at UBS argue in a recent report that the banks will be tempted to ramp up dividend payout ratios.
"Given the franking credit regime in Australia and shareholders' desire for yield investments, we believe there is a significant incentive for the boards to return much of this free cash flow to shareholders in the form of higher dividend payout ratios," the analysts say.
However, they question whether this approach is prudent for the banks given the current environment, the banks' leverage to changes in asset quality, and the current signs of stress across many sectors of the Australian economy.
Therefore, the analysts argue that an alternative approach may be for the banks to deliver steady growth in their ordinary dividend with a payout in the 65 to 75 per cent range, and then for them pay out any excess capital generation via a special dividend in years when asset quality is benign.
"This would avoid the need to cut the ordinary dividend in periods when asset quality deteriorates - something we believe boards would try to avoid - while enabling the active management of capital and distribution of franking credits," they say.
Morningstar head of Australian banking research David Ellis tends to agree that a more active use of special dividends is one capital management initiative the banks should consider - just so long as the Australian economy "doesn't go down the drain".
"What we've been saying is that we expect the major banks to enter into some type of capital management initiative - maybe in 2013, maybe towards the end of 2013. And what we've been talking about looks like it's coming to fruition," Ellis says.