Our banks should survive with dividends intact

Canadian banks are better capitalized and less leveraged than the global peer group, writes Murray Leith

By Murray Leith
Globe Investor Magazine Online, Feb. 2, 2009

Murray Leith is director of investment research at Odlum Brown in Vancouver.

Bank dividend yields are so fantastic compared to fixed income alternatives that many investors are wondering if they are too good to be true. With the possible exception of Bank of Montreal, we believe that investors can expect full dividend payments in 2009. Longer term, the safety of Canadian bank dividends hinges on the health of the global economy.

While we remain optimistic that the global economy will stabilize later this year or in early 2010, there is a risk that the global recession will run longer and deeper and that Canadian banks will reduce dividend payments.

Considering that the banks are actively raising additional capital to placate nervous investors, it is possible that the banks will adopt more conservative dividend payment policies until the economic storm passes. Regardless of what happens to dividend payments in the near term, we are confident that Canadian banks will survive the economic storm and that investors will be well rewarded over the long haul.

The average Canadian bank stock has a dividend yield of more than 7 per cent. That is almost triple the yield on 10-year Government of Canada bonds and more than the yield on the typical investment grade Canadian corporate bond.

Because bank dividends qualify for the enhanced dividend tax credit, they are much more valuable to taxable investors than a similar amount of interest paid on a bond. In fact, for a taxable British Columbian investor in the highest tax bracket (reached at an income level of $126,000), a 7-per-cent bank dividend will provide as much after-tax income as a bond with an interest rate of 10 per cent.

Normally, bank dividend yields are close to half the yield offered on long-term government bonds, as equity investors forgo current income (yield) in return for the prospect of future dividend growth and capital appreciation.

Historically, investors have been well compensated, with the big six Canadian banks providing an average compound annual return, including reinvested dividends, of 16 per cent for the 20 years through to the end of 2007.

But these are not normal times. Investors have been given many reasons to agonize about the safety of bank dividends. Iconic financial firms that paid dependable dividends for decades, like Bear Stearns, Lehman Brothers, AIG, and Merrill Lynch, have either gone bankrupt, been rescued by the U.S. government or been taken over by a healthier competitor.

Canadian bank stocks, although battered, have held up much better because they are perceived to be fundamentally stronger businesses operating primarily in a stronger country (Canada). Canadian banks are better capitalized and less leveraged than the global peer group. Furthermore, the Canadian government has more flexibility to stimulate the Canadian economy with expansive fiscal policies (increased spending and tax cuts) because our federal debt-to- GDP ratio is the lowest among the G7 countries.

While there is little doubt that Canadian house prices are headed lower, we believe that the Canadian residential real estate correction will take a significantly lesser toll on our banking system than the experience in the United States. Speculative subprime mortgages were significantly less prevalent in Canada during the boom times than they were in the United States. Moreover, our banks are prohibited from issuing residential mortgages with greater than 80 per cent loan-to-value unless the entire loan is insured by a third party (usually the Canada Mortgage and Housing Corp.).

The Canadian banking sector's exposure to the cyclical construction, resource, manufacturing and communications sectors is meaningfully lower than it was heading into past recessionary cycles, as the banks have increasingly concentrated on building their consumer lending franchises. This reality, together with the fact that fee-based income is a higher percentage of revenue today, provides further reassurance that our banks are in relatively good shape.

Although the foregoing observations provide comfort regarding the stability of Canadian bank dividends in the near term, investors must appreciate that the health of the Canadian economy and our banks is at the mercy of economic forces beyond our borders. With resource prices cratering, house prices falling, construction activity ebbing and the auto sector in disarray, we believe that the Canadian economy will deteriorate faster than expected. As such, share price weakness and nervousness regarding bank dividends could intensify in the short run.

We remain hopeful that global economic conditions will stabilize and that the Canadian economy will find its footing before bank dividends are jeopardized. The world's governments and central banks have taken significant and decisive action to restore confidence in the financial system and stabilize the world economy.

There is simply too much effort being put forth to resurrect the world economy to be overly pessimistic about the medium and long-term outlook. If the global economy gets traction later this year or in early 2010, there is a good chance that the Canadian banks will survive the cycle without having to reduce their dividends.

Special to The Globe and Mail