Since 23rd June 2023, the KSE100 index has rallied 61%. On the other hand, the Banking Tradable Index (BKTI), which constitutes Pakistan’s major banks, has rallied 75%. And this is despite the fact that the KSE100 index is a total return index (incorporates both capital gains and dividends), while BKTI index is a price return index (only includes capital gains).
The banking sector is one of the few sectors which have outperformed the broader-market indices over the past year. And why wouldn’t it when it offers an attractive dividend yield? The average CY23 expected dividend yield for BKTI stands at 12.3%. If you swap out Bank of Punjab for Standard Chartered in the index, that number goes up to 15.6%.
That contextualizes a major reason behind the banking rally: yield compression. Simply-speaking, assets of similar risks must deliver similar yields. When the IMF announced the Staff Level Agreement in late June 2023, the risk associated with Pakistani assets went down, thus yields on stocks had to compress – especially those that pay high, regular dividends. Moreover, with expectations of interest rate cuts in 2024 rising and macros getting better, that risk continues to fall thus boosting asset prices.
But why does the banking sector trade at a dividend yield far beyond 10% when the market as a whole is trading below that cutoff now? The market might still be pricing in idiosyncratic risk associated with the banking sector. Aka the risk of (domestic) debt restructuring.
However, the chances of domestic debt restructuring might be far lower than the market expects. Why? Well, commercial banks have been simply doing what the Finance Ministry and SBP expects of them – acting as a chain between SBP and the government for lending.
Wiping out bank capital is not exactly a good reward for obeying such ‘indirect’ orders. It would permanently damage confidence in the domestic debt market and make it difficult for the government to reliably issue debt over the long run. Hence, no domestic federal debt restructuring has taken place in Pakistan’s history even as external debt has been restructured.
Moreover, it is not domestic debt which is unsustainable but rather external debt. Much of the government’s international borrowing took place at an interest rate of 6-9%. This is far higher than the long run growth rate of Pakistan at 4.8% (i > g here). If you further deconstruct the borrowing, the unsustainability of it becomes clear.
Borrowing externally at a rate of 6-9% and adding in natural long-run depreciation of 5-8% translates to a rupee cost of debt of 11-17%. Historically, rupee cost of local debt has been 8% in Pakistan.
As external financing conditions improve, the need to borrow from domestic markets will reduce, thus making local debt more sustainable.
What’s the best news among all this? Banks might actually be the biggest winners from falling interest rates. Sounds counterintuitive but it’s true. Yes, net interest margins would reduce slightly affecting profitability but falling interest rates would reduce the government’s debt servicing bill and give it some fiscal breathing room. That itself would largely alleviate the risk of debt restructuring, thus boosting asset prices. Interest rates being at 22% are not the norm but rather an anomaly (remember: historically, interest rates have averaged 8% in Pakistan).
Furthermore, falling interest rates would mean further yield compression as more investors rush to equities. There are still several banks which trade at attractive dividend yields – a couple offering even more than the risk-free rate.
So which banks would be good targets? Certainly, banks which offer a tasty dividend yield. They would benefit most from the yield compression and would act most as bond proxies which generally tend to rally in a falling interest rate environment. If you go back to 2021, banks like UBL and MCB were trading at a PE of 8 and at a dividend yield of 10-12%.
Besides this, banks which could potentially increase payouts would unlock significant shareholder value. This is because excess cash sitting on the books would be returned to shareholders.
With banks like Standard Chartered and Bank Al-Habib doing just that over the past year, there would be pressure on other banks to follow suit given the massive increase in earnings as of recent.
MCB and Bank Alfalah (BAFL) could be potential banks increasing payouts. 5-year dividend payout ratio for BAFL and MCB stands at 53% and 80%, respectively. EPS for CY23 is expected to come in at Rs 23 per share and Rs 50 per share for BAFL and MCB, respectively. That leaves massive room for a large Q4 dividend if BAFL and MCB stick to their dividend payout ratio trend of the past five years.
The earnings season fever might be the trigger to unlock further value in banks. And it lurks just around the corner now…