Bond yields are rising across the globe as inflationary fears balloon. While this might be bad news for bond prices and equities sensitive to inflation, it could be news good news for Australia's big banks as rising yields have historically widened interest rate margins and pushed up profits.

Higher bond yields should be “beneficial” for bank profits, says Morningstar banking analyst Nathan Zaia.

“As bank funding costs rise, we would expect them to stop being as aggressive on discounting lending rates on new loans, but at some point, begin to reprice their back book," he says.

"Because the major banks have a funding cost advantage over smaller banks and non-bank lenders, who rely more on term deposits and securitisation markets, we expect the market to follow the lead of the majors."

Drew Meredith, director and adviser at Wattle Partners agrees, saying higher bond rates typically afford banks a greater opportunity to increase their net interest margins (NIM), which are sitting near all-time lows.

The core activity of most banks is lending and they make money from this by lending at interest rates that are higher than what they pay for their funding. The NIM (the ratio of net interest income to interest-earning assets) is therefore a key indicator of bank profitability. As interest rates rise, margins typically widen.

“That said, a single factor doesn’t determine bank performance and profitability. Banks must balance loan growth, loan quality and their pricing in order to gain market share and continue to grow,” says Meredith.

Major Bank Net Interest Margin

In response to these inflationary fears, the yield on Australian 10-year government bonds has jumped almost half a percentage point to 1.74 per cent as of 18 October, while in the US 10-year Treasury yields have by less, to 1.57 per cent, up around one-fifth of a percentage point.

Commonwealth on top

According to the Reserve Bank of Australia's Financial Stability Review, published this month, banks’ profitability increased over the first half of 2021 returning to the levels seen before the pandemic.

The strong property market has benefitted the banks that are writing a record level of home loans. The Commonwealth Bank has benefited the most as it has the biggest home loan book and the most efficient loan processes.

“The housing boom has helped all banks, but I would say CBA has been the biggest beneficiary because it has been able to keep up with the flood of loan applications better than peers,” says Zaia.

“In a hot market, homeowners want answers quickly, and if mortgage brokers are not getting an approval as quickly as needed, they will move on to another lender."

Meredith says the Commonwealth Bank stands out as the leader by far in terms of market share and profitability, hence its valuation ahead of the others. He wouldn't be surprised to see it exceed its current market value of $105.

"It has the most deposit funding, so is less reliant on overseas borrowing, and remains one of the best banks in the world," he says.

"Looking back at the last 10 years and you can see that whilst CBA has doubled its profits, most of the key competitors have stagnated, along with their share prices. On a medium to long-term basis, CBA stands out and exceeding $110 per share isn’t unachievable.”  

APRA intervention

The recent intervention by the Australian Prudential Regulation Authority (APRA) may weigh on the banks’ profitability, however, and their ability to write home loans, particularly for younger borrowers.

APRA recently increased the minimum interest rate buffer it wants banks to use when assessing home loan applications, telling banks to assess new borrowers’ ability to meet their loan repayments at an interest rate that is at least 3.0 percentage points above the loan product rate. This compares to a buffer of 2.5 percentage points that are commonly used by banks today.

APRA’s decision reflects growing financial stability risks from banks’ heavy residential mortgage lending. Morningstar’s Zaia believes CBA and Westpac are the most exposed to intervention by APRA.

“It is difficult to assess how each bank will be affected by new lending restrictions, given limited disclosure of debt/income statistics on new loans or the entire book. All banks will argue they are lending prudently though," he says.

"Given home loans make up around 70 per cent of Commonwealth Bank and Westpac’s loan books, both should be affected more than ANZ and National Australia Bank with home loans making up around 60 per cent of total loans.

Excluding the Commonwealth Bank, their share prices are not overly priced or expensive, adds Zaia.

“We do not believe wide moat-rated major banks’ shares are priced for the current credit growth rates to continue," he says.

"Westpac currently trades at a 12 per cent discount to our $29 fair value estimate, ANZ Bank around 4 per cent discount to our $29 fair value estimate, National Australia Bank at a 10 per cent premium to our $26 fair value estimate.

"Commonwealth Bank is the outlier, trading at a 23 per cent premium to our $83 fair value estimate."