The past couple of weeks have delivered a timely reminder of the difference between earning interest on a bank account and earning dividends on shares.
While the interest payments on bank accounts are literally guaranteed on a number of levels, no such guarantees exist for share dividends.
Dividends are often many times higher than the yield that you can get on cash but treating them as a certainty doesn’t work at all times.
Yield funds are hurting
The glossy brochures for “yield funds’’ certainly don’t tend to mention the fact that dividends can be cut or suspended but over the past couple of weeks a lot of those funds have struggled as the big banks either cut their dividends or suspended them altogether.
With banks paying out about 30% of the dividends on the ASX 200 – almost $24 billion last year – those suspensions and cuts leave a really big dent in the dividend account of many listed and unlisted yield funds.
Banks almost unanimous in cutting or suspending dividends
The first shock was when National Australia Bank (ASX: NAB) cut its dividend by 64% to just 30c a share.
Commonwealth Bank (ASX: CBA) won’t be reporting until August but it would be surprising if it didn’t also announce a dividend cut or suspension.
There are a number of reasons behind this drastic reduction in dividends but the major one is regulatory with the Australian Prudential Regulation Authority (APRA) last month effectively ordering bank boards to seriously think about hitting the pause button on the payments.
Worse than that, APRA effectively warned that it would like to be kept informed about how the bank boards arrived at their decision, which is enough to put the shivers up the spine of any bank board member.
There are good reasons for cutting dividends
There are also some very sound business reasons for suspending or cutting dividends.
Banks are highly leveraged so they are very susceptible to reversals in economic conditions ranging from property valuations to employment, rental markets and business conditions.
The COVID-19 pandemic has injected a lot of uncertainty around all of those variables and we don’t really know where the economy will end up at the end of this crisis or even what sort of time frame there will be.
The sort of pandemic is a once in a century occurrence and it only makes sense for the banks to cut dividends going into the crisis – along with increasing provisions for bad loans and downgrading profit expectations.
Preserving capital can be vital
Reducing or suspending dividends also preserves capital and reduces the risk of equity raisings that can dilute shareholdings.
Still, reduced and delayed dividends are tough for those who are depending on them, including retirees and investors who are prepared to take on a bit more risk to get a higher yield.
Australia’s system of dividend imputation has also encouraged a lot of investment in banks, as have the savage reductions in interest payments on bank deposits.
Dividends usually better than bank deposits
Traditionally, it has always been better in yield terms to invest in bank shares rather than taking out a bank deposit but many investors may have been seduced by high yielding banks shares without realising that those bi-annual payments are far from guaranteed.
There is also a very big chance that when the uncertainty settles, the period of very large bank dividends could come to an end, with a reduction in payout ratios.
Many analysts believe that payout ratios could fall to around 50% or 60% of profit rather than the more customary 70% to 80% which ruled before the current crisis.
Time will tell but one thing is for sure, the long history of relying on bank dividend payments coming around twice a year like clockwork has come to an end.
Like all things, the higher the yield the higher the risk so the bank dividend reductions shouldn’t come as an absolute shock.