Investors have largely avoided financials over the past 10 years, with the share prices of US and European banks having largely stood still relative to broader markets since 2007. But while banks won't return to their record valuations any time soon (and probably rightly so), they make for an increasingly interesting income story.
US repairs complete. Finally
In the US, equity investors are now poised to benefit from the repair work that has been undertaken since the financial crisis. All 34 of the major US banks passed the Federal Reserve's stress tests in June, with the Fed sanctioning plans to return capital to shareholders for all banks bar one.
According to Moody's Investor Service, most US banks' planned dividends and share buybacks will now exceed 100% of trailing 12 month net income over the next year. Citigroup, for example, will pay out 23% of its trailing 12 month net income in dividends, and 100% in planned share buybacks.
Financial equities should therefore deliver a good income story for investors. At the same time, the capital side will remain well supported, with share buybacks, relatively low valuations and the potential for rising dividends all helping to limit downside risk.
More risk could pay in Europe
There are also opportunities in Europe, particularly on the debt side. In response to capital structure issues after the financial crisis, regulators encouraged European banks to issue a new type of bond: contingent convertibles. These are higher yielding than other fixed income instruments, as they carry the additional risk of converting into equity if a bank falls into difficulty. But with the improved state of European bank balance sheets, we believe investors are being adequately compensated for this risk, although it still pays to be selective.
As the eurozone economy improves, bank balance sheets should also further improve. European loan demand was at its strongest for more than a decade in 2016, which should help to boost bank profits.
A stronger economy should allow the ECB to gradually unwind its very loose monetary policy, especially its negative interest rate policy, thus boosting the profit a bank can earn on each of its loans. These are important tailwinds for European financials and should help to support sentiment towards the sector.
For income investors, banks therefore offer opportunities on both sides of the Atlantic. While there are different reasons for investing in US and European banks, one common rationale for income investors is to protect themselves against the prospect of rising interest rates.
Banks are one of the few sectors that tend to benefit from higher rates. They can also help to offset more interest rate sensitive areas of a portfolio such as government bonds. Given the uncertainty around monetary policy, some protection against rate rises looks to be warranted.
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Note the value of an investment and the income from it can go down as well as up, so you may get less than you invested and tax rules and allowances can change. The ideas and conclusions featured are the author's own and do not necessarily reflect views being actively implemented in Fidelity's range of investment products and solutions. They are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security. Past performance is not a guide to what may happen in the future and any figures and returns quoted are purely to illustrate the author's points unless stated otherwise.
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