The context: bad and doubtful debts
Over the past two-and-a-half years, the revival in banking securities has partly been due to record cash earnings, which have benefited from record low levels of bad and doubtful debt (BDD) provisions.
There has been a concerted change in market pricing in the Big Four banks on the back of recent revelations from ANZ. Exposure to Peabody and Arrium has caused the bank to re-provision its bad and doubtful debts by $100 million.
Westpac has also laid the groundwork for increasing its bad debt provision due to consumer and business exposures.
If the exposures do force a shift in the bad debt cycle and provisioning is revised upwards, then cash earnings will be adversely affected. And this brings up another interesting security price dilemma: yield.
The importance of yield
Yield has been one of the biggest reasons cash has poured into the banks between 2013 and 2015. Net yields have been as much as 400 basis points above the cash rate. Pay-out ratios over this period also expanded as the housing-led recovery added to record cash earnings, allowing boards to increase dividends at all four Big Four banks.
Increases in bad and doubtful debts would have an adverse impact on cash earnings and payout ratios. And any sign that dividends may come under threat is likely to give market pricing another reason for a further leg lower.
Digging deeper: ANZ
ANZ is trading at one of the largest valuation gaps to peers of the past five years and I believe the fundamental price risks could be considered to be upside rather than downside.
However, the technicals suggest ANZ could retest the March lows, having failed to break out of the downward channel of the past 10 months.
In terms of near-term upside risks, it’s possible ANZ is oversold on provision risks and ‘deep value’.
Near-term downside risks include the release of half-year numbers on 3 May. There’s a chance ANZ may realign its strategy in light of its Asian Bank exposure and resource loan exposure.