Investors are nervous about the effects on equity markets of rising 10-year bond yields in Canada and the US, explains Gavin Graham, a leading specialist in Canadian investing and contributing editor to Internet Wealth Builder.
Some investors point to the sharp falls in the big US bank stocks. The concerns are that the sharp rise in interest rates will cause a recession, rising unemployment, and an increase in bad debts.
Given the sharp increase in corporate indebtedness, as companies took advantage of generational lows in interest rates, these fears are well founded. There is worry that the same factors will hurt the performance of the Canadian chartered banks.
There are several reasons why the Canadian banks have outperformed their US counterparts so far in this interest rate cycle. Perhaps the most important is the oligopoly the Big Six banks enjoy, which leads to wider spreads and better margins.
Rising interest rates are good news for banks, which increase the rates paid to depositors more slowly than those charged to borrowers. Obviously, if bad debts rise sharply, this benefit is negated.
Other reasons for the better performance of Canadian banks include their geographical diversification, with large international operations. As well, they enjoy a commanding position in asset management in Canada and large capital markets operations. As a result, their business risk is not directly related to the interest rate cycle.
One last reason for Canada performing better is its commodity exposure. Rising energy and materials prices are among the reasons for the Consumer Price Index rising 8% over the last year. A natural resource-based economy like Canada is much better positioned to gain benefits from this development, as occurred during the 1970s and the 2000s.
RBC Group (RY) is Canada’s largest banking group by balance sheet and market capitalization (it’s larger than Wells Fargo, Morgan Stanley, and Goldman Sachs). It has leading positions in Canadian retail and commercial lending, asset management, and investment banking.
With the cap on dividends removed in the fourth quarter, RBC raised its quarterly payment by 11% to $1.20, giving it a yield of 3.7%. This represents a 47% pay-out ratio.
With the share price down from its all-time high of $149.60 in January and selling at a p/e ratio of 11.4 times, near its low for the last five years, RBC remains a "Buy" for its market leading positions, growth in asset management, and strong capital base. It has a CET1 ratio of 13.5% and is rated AA by S&P and Aaa1 by Moody’s.
TD Bank (TD) is the sixth largest bank in North America by total assets, number of branches, and market cap. It has more branches in the eastern US than in Canada and is one of the leading on-line financial firms, having merged its TD Ameritrade discount brokerage with Charles Schwab (SCHW) in the US in 2020, leaving it with a minority stake in Schwab.
After the removal of the dividend cap, TD raised its quarterly dividend 12.6% to $0.89, giving it a yield of 3.8%. The stock is down 16% from its all-time high in January.
I consider it to be a "Buy" on its reasonable p/e valuation of 11.7 times, the additional growth in the US the deal brings, its strong asset management division, and the possibility of realizing its stake in Schwab to increase its capital ratio.
Bank of Nova Scotia (BNS) — known as Scotiabank — is the most internationally oriented of the Big Six Canadian chartered banks, with approximately 35% of its earnings coming from its international operations, primarily from Mexico, Colombia, Peru, and Chile.
While this has been regarded as a drag on results for the last few years, the bank has sold off smaller and less profitable operations in the Caribbean, Asia, and Latin America, and it appears the corner has now been turned.
The bank trades at a price/earnings ratio of 10.29 times with rebounding earnings. It has been an underperformer amongst the banks over the last couple of years but is now well positioned to benefit from rising interest rates and margins, expanding wealth management business, and the turnaround in its international operations. The stock is a "Buy".