Up until the last decade, banks were viewed as stable (and even boring) businesses that threw off lots of cash that could be returned to shareholders in the form of dividends. But during the financial crisis, banks caused plenty of pain for investors who held their shares in hopes of getting a dividend payout.
Now advisors must consider whether bank stocks pose a particular risk to dividend-focused clients.
Take Bank of America, which at the end of 2007 was one of only 60 stocks in the S&P 500 index that had increased dividends annually for 25 or more years -- a group known as the Dividend Aristocrats. In calendar-year 2007, the bank paid an annual dividend of $2.40 per common share.
A year later, it was one of six financial services companies (five of them banks) to be dropped from the Aristocrats list; by 2009, the dividend was down to $0.04 a share, where it remains today.
According to S&P Dow Jones Indices, which compiles the list, six financial services companies are in the current roster of 54 S&P 500 Dividend Aristocrats. Three are insurers, two are asset managers and one is a REIT -- not a bank to be found.
DERIVATIVE RISKS
But advisors who are investing in dividend-oriented ETFs for clients are likely to find banks in many of them -- if not Bank of America, then perhaps a financial giant like JPMorgan Chase. JPMorgan paid a dividend of $0.38 a quarter before the crisis, fell to $0.05, and now is back to paying $0.38.
Should that be a concern? It might be, if you worry about derivatives -- those financial contracts whose value depends on the performance of something else. (Warren Buffett called them financial weapons of mass destruction.)
According to the Office of the Comptroller of the Currency (OCC), 1,417 insured U.S. commercial banks and savings associations reported derivatives activity at the end of 2013s third quarter -- the most recent period for which data are available.
As for JPMorgan: The OCC reports that its total credit exposure is 205% of its capital. The notional value of its derivatives is $71.8 billion, while its assets are $1.99 billion. People buying funds that hold JPMorgan could end up taking a hit to yield (as well as facing some capital loss) should another "London whale"-type incident occur.
WHERE THE BANK STOCKS ARE
As the following chart shows, each of the five largest dividend-oriented ETFs currently has some financial services exposure, ranging from 1.71% for the iShares High Dividend ETF (HDV) to 21.93% for the SPDR S&P Dividend ETF (SDY).
Advisors who are worried about banks might want to consider the Vanguard Dividend Appreciation ETF (VIG), for instance; even though 7.8% of its assets are in financials, the fund has no current exposure to banks. For the iShares High Dividend, the biggest bank position amounts to only 0.14% of assets.
The other big players, however, have somewhat higher exposure. The largest bank position in the SPDR S&P Dividend ETF is Peoples United Financial, which at 1.95% of assets is the funds fifth-largest holding. Vanguard High Yield Dividend ETF (VYN) has two banks in its top 10 holdings: Wells Fargo is roughly 3.21% of the fund, while JP Morgan Chase accounts for 2.97%. For WisdomTree LargeCap Dividend Fund (DLN), Wells Fargo is the eighth-largest holding at 2.11% of the portfolio and JP Morgan Chase ranks 13th at 1.83%.
Should advisors avoid any dividend funds that hold bank shares? Not necessarily. But the OCC numbers can help to focus the derivatives discussion. According to the OCC, four banks (JPMorgan Chase, Citibank, Goldman Sachs Bank and Bank of America) represented 93% of the notional amounts of derivatives in the industry and 81% of the credit exposure at the end of 2013s third quarter.
Something could go wrong. And even if it doesnt set off another crisis, you could see these banks dividends slashed again.
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