Rising interest rates lend Canadian banks greater allure

Higher borrowing costs create a favourable environment for financial institutions.

Vikram Barhat 1 February, 2018 | 6:00PM

Barely three weeks into 2018, the Bank of Canada has already increased the benchmark rate by a quarter-percentage-point, or 25 basis points, to 1.25% in January. It was a stream of upbeat news and numbers around Canada's economy, robust job gains and steadily falling unemployment that prompted the central bank to proceed with the third rate hike since last July.

As the overnight rate continues to march toward more normal levels, it's the first time it has edged above 1% since 2009. So confident were leading Canadian banks that they raised their interest rates on a variety of rate-tethered products, including mortgages, days before the expected central bank rate hike.

While rising rates typically sound a cautionary bell for borrowers and consumers, they create a favourable environment for financial institutions where strong economic indicators and expectation of improved profitability conspire to create a growth tailwind for the sector. For dividend-seeking investors, this warrants a closer attention to leading Canadian lenders, which collectively hold 90% of the nation's banking deposits.

Diversified businesses, strong suites of services, geographical expansion and strong capital reserves provide these financial juggernauts a long runway of continued growth, making them compelling investments when borrowing costs are edging higher, according to Morningstar equity research.

 

The Toronto-Dominion Bank
Ticker: TD
Current yield: 3.23%
Forward P/E: 12.5
Price: $74.68
Fair value: $76
Data as of Jan. 30, 2018

One of Canada's two largest banks,  Toronto-Dominion (TD) operates three business segments: Canadian retail banking, U.S. retail banking and wholesale banking. The bank's Canadian operations generate 60% of its revenue while 35% of it is derived from the United States, and the rest from other geographies. The Canadian banking behemoth also owns a 42% stake in TD Ameritrade, a stateside discount brokerage.

TD has done a tremendous job of growing its Canadian retail operations, climbing to number one or two in market share for most key products, while maintaining a number-two market share in the business banking segment. "With roughly $350 billion in assets under management, top-three dealer status in Canada, and being the number-one card issuer in Canada, we expect it to remain one of the dominant Canadian banks for years to come," says a Morningstar report.

With interest rates rising and the Canadian economy humming, TD, like other leading Canadian peers, is well positioned to benefit from increased bank loans and capital markets activity. Higher cost of borrowing tends to pad up margins on loans, leading to larger profit and juicier dividends.

Wide-moat TD Bank reported a solid fourth-quarter wherein it registered a higher operating margin and a lower tax rate than projected. Although lower trading volume weighed on wholesale banking, "loan balances grew at a healthy pace and net interest margins continued to recover to levels previously seen at the beginning of the year," says a Morningstar equity report, noting that "additionally, assets under management growth remained strong in Canada."

The strong quarterly results prompted Morningstar equity analyst Eric Compton to raise the stock's fair value from $73 to $76. "Overall, we like Toronto-Dominion's exposure to the U.S. wealth market, its continued retail strength in Canada, and its history of conservative underwriting," he says.

 

Bank of Montreal
Ticker: BMO
Current yield: 3.46%
Forward P/E: 12.0
Price: $102.69
Fair value: $104
Data as of Jan. 30, 2018

Canada's fourth-largest bank, and the second-largest asset manager,  Bank of Montreal (BMO) offers retail banking, wealth management and investment banking products to more than 12 million customers in Canada, the U.S. and other global markets. The bank derives roughly 70% of its revenue from Canada and nearly 25% from the United States.

"With its more commercially focused book, it boasts good share within its domestic commercial lending market, at number two for loans under $25 million," says a Morningstar report, noting that "BMO has the lowest relative exposure to residential mortgage loans among its peers, helping to mitigate some of the risks within its loan book."

Over the past several years, BMO has been building its commercial lending strength in the U.S. with high-single-digit loan growth rates expected. "In general, we like BMO's presence in the U.S., as it has built up respectable deposit market share numbers and has avoided some of the mistakes other Canadian banks have made in attempts to expand south," says Compton, who recently upped the stock's fair value from $98 to $104, prompted by strong fourth-quarter earnings.

As rates rise on both sides of the border, the net interest margin for BMO should expand slowly but steadily. "Growth and opportunities in the bank's U.S. markets will outweigh any slowdown in its native Canada as U.S. subsidiaries gain market share," says Compton, whose forecast puts the bank's average loan and deposit growth at 4% to 5%, operating income growth at 6% and average returns on equity at 15% through 2022.

 

Royal Bank of Canada
Ticker: RY
Current yield: 3.39%
Forward P/E: 13.0
Price: $105.45
Fair value: $105
Data as of Jan. 30, 2018

 Royal Bank of Canada (RY) is one of the two largest banks in Canada which offers diversified financial services -- personal and commercial banking, wealth management and investment banking -- to 16 million clients in more than 35 countries. The bank derives two thirds of its revenue from Canada, with the U.S. and the Caribbean contributing most of the rest.

"It has done an admirable job of expanding its nonbank lines of business, running efficient banking operations and generating some of the best returns for shareholders in the industry," says a Morningstar report. "With over $5 trillion of assets under administration and over $500 billion of assets under management, strong global capital markets operations and a dominant share of domestic banking operations, it should remain one of the dominant Canadian banks for years to come."

Royal Bank continues to be a major player in global capital markets. Last year, the Switzerland-based Financial Stability Board added RBC, the only Canadian bank, to its list of global systemically important banks considered too big to fail.

Also in 2017, RBC was in the top 10 of the league tables internationally for offerings based on deal credit. "We expect this segment to continue to be a strong contributor to net income," says Compton. "The wealth management segment also earns strong returns on equity, and large inflows have led to a dominant market position."

Compton recently raised the stock's fair value from $97 to $105 while forecasting average loan and deposit growth of roughly 3% each, and annual growth of 5% for operating income, through 2022.

 

Canadian Imperial Bank of Commerce
Ticker: CM
Current yield: 4.23%
Forward P/E: 10.7
Price: $121.60
Fair value: $131
Data as of Jan. 30, 2018

Canada's fifth-largest bank with more than $565 billion in assets and 11 million clients worldwide,  Canadian Imperial Bank of Commerce (CM) offers a bouquet of financial products and services under retail and business banking, wealth management and wholesale banking segments.

More Canadian-focused than some of its peers, CIBC generates over 80% of its revenue in the high-return domestic banking market. The lender, however, "remains focused on expanding in the U.S., aiming to get as much as 25% of total business from there over the long term," says a Morningstar equity report.

U.S. expansion and potential pressures at home, though, could drag down return on equity over the medium term for CIBC, cautions Compton, who recently increased the stock's fair value from $114 to $131, prompted by an excellent fourth quarter report.

He cautions the true test for CIBC will come when the credit cycle begins to turn, as CIBC has been one of the most aggressive pursuers of growth, particularly within Canadian real estate. "Not surprisingly, the bank was again the number-one grower within real-estate-secured personal lending for its Canadian retail banking segment," he says.

The bank has also had decent success expanding its wealth operations. "As a result, over the past five years, returns on equity have generally been near 20%, and the bank's operating efficiency appears poised to reach levels not seen for over a decade," says Compton, who forecasts "the high-return Canadian retail banking segment will remain the cornerstone of CIBC's capital-generation capabilities, while expansion in the U.S. should provide the much-needed ability to sell additional products."

Editor's note (Disclosure): The author owns a small position in shares of Toronto-Dominion Bank.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
Bank of Montreal97.22 CAD0.63
Canadian Imperial Bank of Commerce109.88 CAD0.44
Royal Bank of Canada106.29 CAD0.38
The Toronto-Dominion Bank76.03 CAD0.45

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Vikram Barhat

Vikram Barhat  Vikram Barhat is a freelance writer.