The Canadian central bank recently surprised the world by enacting a 100 basis point rate hike. That has investors worried that central banks are behind the curve when it comes to inflation and that their belated efforts to reduce it could plunge global economies into a recession.
That's why bank stocks like Toronto-Dominion Bank (TD 0.27%) have been trending lower, since neither outcome would be particularly good for these vital financial institutions. But that's an opportunity for long-term investors to add a generous 4.3% yield to their passive income stream.
The bad news isn't over
Toronto-Dominion makes money in a few different ways, but one of the bank's important focuses is on simple relationship banking. That means that it takes in money from customers in the form of deposits and lends out the money to other customers for things like buying a home (mortgages). It earns the difference between the rates it pays depositors and the rates it charges on loans. That's a huge simplification of the banking business, but it gets to the core of what Toronto-Dominion does.
Although these services are pretty much a necessity of modern life, interest rates and economic cycles play a big role in how well, or poorly, banks perform over short periods of time. For example, the historically low-interest-rate environment has squeezed margins at banks. And while rising rates are a good thing because they should allow banks to charge higher rates for the loans they make, there is a notable risk today that rate hikes like the one enacted by the Canadian central bank will lead to a recession.
A recession will almost certainly mean less business for banks, as loan volume slows. And, perhaps more problematic, troubled customers are likely to have difficulty paying their current loans. Increasing bad loans means banks have to absorb the losses from loans that aren't likely to be repaid.
It looks like the cycle is just at the start of such a rough patch for banks, and investors are moving proactively to limit their exposure. Toronto-Dominion stock, for example, is down by 17% so far in 2022, and a full 25% from its high-water mark in February.
An opportunity for long-term investors
The drop in Toronto-Dominion's stock has pushed the yield up to 4.3%. The dividend yield is at the high side of its historical range, suggesting that the stock is relatively cheap right now. Given the backdrop, that probably makes some sense -- but it has to be couched in the long-term picture for this bank.
Toronto-Dominion was founded in 1855. It has seen its fair share of economic cycles over the past 100 years or so. And it has long operated in a conservative manner, which is partially related to its Canadian home market. Canada's banking market is highly regulated, and the biggest banks, a list that includes Toronto-Dominion, basically have entrenched positions.
One way to understand Toronto-Dominion's conservative nature is to look at its Tier 1 ratio. This number is basically a measure of a bank's ability to weather hard times with higher numbers better than lower ones. At the end of the fiscal second quarter the bank's Tier 1 ratio was 14.7%, the second highest across all of North America. In other words, there's only one bank in all of North America that's better prepared for an industry downturn than Toronto-Dominion.
Meanwhile, Toronto-Dominion has the No. 1 or No. 2 position in key bank metrics (such as assets and net income) in Canada and the No. 5 or No. 6 spots on such metrics in the United States. This is a key to the long-term story. Toronto-Dominion's Canadian position is basically locked in, but it still has room to grow in the United States. In fact, despite its size in the U.S. market, it largely operates on the East Coast, leaving the rest of the U.S. market for expansion. Although there are worries about the deal falling through, Toronto-Dominion recently inked a $13.4 billion deal to get bigger "south of the border" via its planned acquisition of U.S. bank First Horizon (FHN -1.32%). Industry downturns could open up even more acquisition options.
So the story for Toronto-Dominion is that the company is a conservatively operated bank that is well positioned to weather what seems like a likely economic downturn in the near term. The higher rates now showing up could trigger that weak patch, but may actually help the company's long-term profitability. And it is using a strong Canadian core business to expand and grow in the United States. Given the company's long and successful history and high yield, it seems like the benefits outweigh the risks here.
Bad and then better
The next year (maybe two) could be hard on Toronto-Dominion Bank. But this period is likely to just be a blip on the company's long-term path toward sustainable long-term growth. More importantly, if you can step in while other investors are fearful about short-term headwinds, you may just pick up a long-term dividend gem.