In this guide
Now that the Reserve Bank of Australia (RBA) has begun to cut the official cash rate, debate about the impact on bank profits has intensified.
So, what does this mean for self-managed super fund (SMSF) investors who rely heavily on bank shares for their dividend income as well as capital growth?
To paraphrase Mark Twain, reports of the death of the banking sector have been greatly exaggerated. After a dividend ‘bloodbath’ during the COVID crisis, when major banks cut or suspended dividends, bank shares rebounded and dividends were restored.
Bank shares and the interest rate cycle
Banks traditionally do well when interest rates are high because they earn more on their lending. Against a backdrop of 13 rate hikes by the RBA from near zero in early May 2022 to a high of 4.35% until the first rate cut in February 2025, it’s no surprise that the banks, and income investors, were making hay. So much so that market watchers began to warn that Australian banks were overvalued.
In 2024, year on year profits for the big four banks fell 5.7% even as their share prices hit new highs. In July 2024, the Commonwealth Bank overtook BHP to become the biggest company on the Australian Securities Exchange (ASX).
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In fact, five of the top seven stocks in the ASX 200 index are banks – Commonwealth Bank, Westpac, NAB, ANZ and Macquarie Group.
The outperformance of the banks during that period was thanks in part to their status as ‘safe haven’ investments, as investors shifted money out of mining stocks hit by falling commodity prices into the banks.
Another factor pushing up bank share prices is the role of big super funds which now own around 30% of the major banks. The strong labour market and an increase in the Superannuation Guarantee (SG) to 11.5% in July 2024 meant more money flowing into super funds looking for a place to invest. A trend that is likely to continue.
SMSFs are also heavily invested in bank stocks. As at June 2024, Commonwealth Bank accounted for 6.7% of all domestic share investments by SMSFs, the largest holding by value. The other big banks also feature in the top 10 holdings.
The lure of dividend income
One of the main attractions of bank shares for SMSF investors is their steady stream of dividend income.
The dividend yield of the overall Australian sharemarket has averaged just over 4% for the past 40 years. In December 2024 the average yield had fallen slightly to 3.77% due to rising share prices.
The impact of rising share prices on dividend yields can be seen starkly in the case of Commonwealth Bank. (Dividend yield = most recent dividend per share/current share price.)
In the year to February 2025, Commonwealth Bank shares rose 40.6%, lifting its share price to 28.9 times earnings and reducing its dividend yield to just 2.86%. At the time, the price-to-earnings (PE) ratio of the overall Australian market was 21.42, well above the rolling 10-year average of 15.94 but lower than the US market on 26.17.
But talk of yields and PEs is academic for long-term bank shareholders happy to pocket a reliable stream of dividend income, albeit with the occasional hiccup. The icing on the cake is franking credits, especially for investors in the tax-free retirement phase.
What are franking credits?
Franking credits represent tax a company has already paid in Australia on any profits it distributes to shareholders by way of dividends. The company tax rate in Australia is currently 30%, or 25% for companies with turnover of less than $50 million.
Shareholders can then use these franking credits, also known as imputation credits, to offset their tax liability on other income, including salary, at the end of the financial year. People who pay no tax, notably SMSF investors in retirement phase, can claim a full tax refund from the Australian Taxation Office (ATO).
If your marginal tax rate is less than the company tax rate of 30%, you would be eligible to receive a refund of the difference between the franking credit and your tax payable.
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That’s why SMSF investors are so attracted to shares in Australian companies that pay fully franked dividends.
Super funds pay a top income tax rate of 15% and no tax on the earnings or income of investments supporting a retirement pension. So refundable franking credits can boost the income yield of an investment substantially. The dividend yield of shares when franking credits are included is called the ‘grossed up’ dividend yield.
The grossed up dividend yield of the overall Australian market is around 5.3% at the time of writing. ANZ had the highest dividend yield of the banks at 5.36% (due to its more subdued one-year price rise of 10.6%), but its grossed up dividend yield was 6.92%.
The highest dividend yield on the market belonged to BHP, at 5.51% and 7.88% grossed up, following a 13% fall in its share price over 12 months.
Beyond the banks
Experienced investors understand the importance of diversifying their investment portfolio, but they are hamstrung by the concentration of banks and miners on the local market.
SMSF investors hold about 20% of their domestic share portfolio by value in the big four banks and Macquarie Group. That’s a lot, but understandable when the financial sector represents almost 32% of the local market. The materials sector, which includes the big miners, accounts for a further 19%.
SMSF investors also hold bank shares indirectly via Australian shares exchange-traded funds (ETFs).
The most popular ETF among SMSF investors is Vanguard’s Australian shares ETF, while Vanguard’s Australian shares high-yield ETF is also in the top 10 holdings by value. High-yield ETFs are popular with SMSFs wanting to maximise income from their investments.
Outside the banks and miners, shares in household names such as Telstra, Wesfarmers, Cochlear and CSL are also popular with SMSFs for their dividend income.
In fact, a host of ASX stocks currently offer dividend yields of 5% or more, but it’s important to look at what’s driving the yield. A high yield could indicate a falling share price, a company with limited growth prospects, or a special dividend.
Even if dividends are your focus, it’s important to keep the big picture in mind. Look for quality, income-producing stocks at a good price. Companies with strong balance sheets and cash flows and good growth prospects.
And think long term. If a quality business experiences a short-term fall in share price or a cut in dividends, there is a good chance it will recover and may even be a buying opportunity.
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Other options
Australian shares are not the only game in town when it comes to generating income.
International shares also pay dividends but at significantly lower levels than the domestic market.
Like shares, investment property provides income in the form of rent as well as capital appreciation. Both listed and unlisted commercial and residential property are popular with SMSF investors.
Traditionally, fixed income investments such as cash, government bonds and high-quality corporate bonds provide stable returns with a low probability of capital loss, or capital guarantees in the case of bank deposits. Hybrids offer higher yields but with higher risk.
Challenging retirement income assumptions
Diversification across and within asset classes is always recommended, but it shouldn’t be assumed that reliable income in retirement will come mainly from the defensive, fixed income portion of your investment portfolio.
Even before the first cut in the cash rate in February 2025, yields on term deposits and Australian government bonds were below gross yields on bank shares and other popular dividend stocks.
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Retirees are also often advised they should have enough cash and fixed income in their portfolio to ride out a share market downturn. This is to avoid having to sell shares into a falling market to fund their immediate living expenses.
Yet retirees in their 60s and early 70s withdrawing the minimum amount from their super pension (4% if you are under 65 and 5% if you are aged 65 to under 75) could, in many cases, fund withdrawals from dividend income with money to spare.
Australian bank shares have rewarded patient investors with reliable income and capital growth for decades. SMSF investors would be wise to ignore short-term noise and focus on the long term.
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