How to Invest in Australian Bank Credit

Generating passive income is a key investment goal for many Australians and a significant portion of those investors may turn to our large financial institutions to do so. However, there is more to the ‘Big Four’ than shares or term deposits. Investors can find opportunities across the full capital structure of banks, including corporate senior and subordinated bonds and hybrid securities, as a way to diversify portfolios with bank credit. Particularly, in a lower interest rate environment when turns on cash are smaller. But what exactly is bank credit and how might investors get exposure?

Let’s X-Plain:

• What is bank credit?
• What are the main types of fixed income issued by banks?
• Why invest in Australian bank credit?
• How to use Australian bank credit in a portfolio

What is Bank Credit?

There are two primary ways for banks to raise money:

1. Equity: selling ownership stakes through shares
2. Debt or fixed income: borrowing money through issuing bonds

Bank credit refers to the latter – the debt or fixed income components across the capital structure (see graph below). Investing in bank credit involves investing in debt instruments, such as bonds, issued by banks in exchange for regular interest payments and their principal at maturity.

Issuing bonds allows banks to access large sums of money without diluting existing ownership. By raising this additional capital, banks can meet the demand for loans, which often exceeds the funds available from customer deposits. Essentially, when the demand for loans surpasses deposits, banks turn to equity or debt capital to fill the gap.

What are the Main Types of Fixed Income Issued by Banks?

There are three main types of fixed income securities available across the capital structure that are issued by corporations like Australian banks:

• Senior bonds – have the highest priority for repayment in the event of liquidation, either secured or unsecured by the company's assets, and are generally considered the safest type of corporate debt.
• Subordinated bonds (Tier 2 Capital) – rank below senior bonds in terms of repayment priority which makes them riskier than senior bonds but typically offer higher yields.
• Hybrids (Additional Tier 1 Capital) – combine features of both debt and equity as their debt may convert into equity based on certain events or triggers. Due to their complex structure and additional risk, hybrids offer higher yields compared to senior and subordinated bonds. Hybrids also have the added benefit of providing investors with franking credits.

Bonds can also have different interest payment structures:

• Fixed rate bond – coupon rate remains constant throughout the life of the bond.
• Floating rate bond – coupon rate fluctuates based on the current level of the benchmark index (such as the bank bill swap rate).
• Indexed bond – coupon rate is linked to a specific metric such as inflation.

Why Invest in Australian Bank Credit?

Fixed income such as Bank credit plays an important role in income generation, capital preservation and portfolio diversification. Fixed income is typically positioned in the defensive portion of a portfolio, emphasising income as the primary source of returns while also providing a defensive cushion during market downturns.

Traditionally, investing in fixed income required large minimum investments, typically only accessible to large banks and institutions trading over-the-counter (OTC) as opposed to on an exchange.  The introduction of ETFs has removed these barriers, allowing individual investors to buy and sell fixed income securities at lower costs, conveniently on the share market.

Instead of buying multiple ETFs to cover different fixed income securities in Australia, the Global X Australian Bank Credit ETF (ASX: BANK) provides exposure to bank credit across the full capital structure in one convenient product. BANK is a cost-effective way for investors to diversify their fixed income exposure while still providing an attractive yield from trusted Australian banks.

How to Use Australian Bank Credit in a Portfolio

Given its defensive, yield-focused nature, Australian bank credit can perform a number of roles in portfolios such as being incorporated into a core allocation or used to complement existing income-generating assets.

• As a core portfolio holding to diversity an investor’s fixed income pillar.
• To provide attractive regular income from trusted Australian banks.
• To delegate decisions on allocations such as fixed vs. floating, senior vs. subordinated, and corporate vs. hybrid using a rules-based approach.