Welcome to the third edition of Questions of the Week. In our most recent posts, we reviewed the challenges currently facing the energy sector and the changes to this year’s Registered Retirement Income Fund (RRIF) minimum payment. This update will focus on another sector that has come under pressure so far this year, the Canadian banks. 

 

Question: Do the Canadian banks currently represent good value for adding to existing positions or starting new ones?

 

As a group, the Canadian banks have underperformed the broad market year-to-date. As of this writing, the TSX is down approximately 16% year-to-date, while the big five Canadian banks have declined on average by approximately 27%. While this price decline has left valuations looking attractive compared to recent years, the question remains as to whether current prices represent good levels to either add to existing positions or initiate new positions in the banks.

 

A Slowing Economy

 

The decline in bank shares is primarily a response to broader economic concerns. The Covid-19 driven lockdowns that have closed large parts of the global economy will likely lead to a global recession in the next few quarters. Here in Canada, we will not be immune to this slowdown. Add in the impact of declining oil prices on the western provinces, and it is unlikely Canada will slip by without experiencing a contraction. In this environment, banks are at increased risk as out of work Canadians may struggle to meet their debt obligations, businesses may reduce their borrowing activity and declining interest rates and equity markets weigh on banks’ capital market operations.

 

We are already seeing evidence of strain creeping into the financial system. Recent numbers show that approximately 670,000 residential mortgages here in Canada were under forbearance as of mid-April. This means that approximately 14% of Canadians with residential mortgages have chosen, or been forced, to postpone their mortgage payments. There are likely many factors at play in each individual decision to apply for a payment postponement, but one that should not be overlooked is the high level of consumer debt the average Canadian household is carrying at this time. In a period in which Canadians are seeing their incomes reduced, or lost, high debt levels will likely translate into higher loan losses for the banks and could weigh on results in the coming quarters.

 

Bank Outlook

 

Despite the above concerns, the outlook is not entirely negative. Canadian banks are well capitalized and in good position to ride out an economic downturn. While loan losses may increase in the coming months, at this time the expectation is that they will not approach levels that will put any of the banks truly at risk. The Canadian financial system remains strong and well regulated, with many checks and balances in place designed to limit the possibility of a financial meltdown similar to what was seen in the U.S. back in 2008.

 

Dividend Yields

 

Another question related to the banks is that of the safety of their dividends. As a result of the recent share declines, bank yields now range between 5% and 7.5%. This represents a significant premium to both historical yields and alternative income options. The concern is that these yields may not be sustainable. A few weeks ago, at the behest of the Bank of England, British banks suspended their dividends. This prompted questions as to whether this might also occur here in Canada. While you can never rule anything out, such a blanket decision to cut dividends appears unlikely at this time. As noted previously, Canadian banks are well capitalized and have a history of maintaining their dividends even in times of significant financial stress. While it is unlikely that dividends will be increasing any time soon, current payout levels should remain safe. This means that anyone buying a Canadian bank share at this time will likely be receiving a minimum of 5% in dividend income while they wait for markets to recover.

 

Time to Invest?

 

In determining whether it makes sense to buy or add to a bank position at this time, it is important to take each of the above factors into account, as well as your own personal financial situation and risk tolerance. Given the above average dividend yields available, and If the investor is comfortable with the potential for further near and medium-term price downside, current levels do represent an attractive long-term opportunity. We would focus on those banks with lower exposures to the energy sector and the retail mortgage market and recommend a gradual approach to increasing any position size.

 

Thank you as always for joining us for another edition of Questions of the Week. Our next post will be available this coming Wednesday. Until then, have a great start to your week and stay safe.