The rising interest rate environment has many investors worried about a recession. Banks are worried too. And yet, higher rates are also a big benefit for banks. How banks manage this economic dichotomy will make a significant difference to their bottom-line profits over the next few quarters.
For investors who focus on the long term, October might be a good time to dig into financially strong banks like Toronto-Dominion Bank (TD 1.23%) and Bank of Montreal (BMO -0.22%). That's because an economic downturn likely won't be as big a headwind for this pair of Canadian giants as you might expect. And the tailwind they will get could be beneficial for investors.
There are two sides to interest rates
Interest rates were very low for a very long time. That's actually hard on banks because much of their revenue is derived from the difference between the rates they pay to depositors and the rates they charge on their loans. Low rates limit the potential spread between the two. With central banks hiking rates to fight inflation, banks have, for the first time in a long time, the opportunity to charge higher rates on mortgages and other loans. And if they drag their feet on the other side, only slowing increasing deposit rates, they can expand their margins and become more profitable. So banks are generally in favor of rates rising.
Image source: Getty Images.
The problem comes when rates rise too much, too quickly. The Federal Reserve's Target Fund Rate has gone from near 0% to 3.25% in a little over six months, which is one of the quickest rates of increase in its history. The incredibly swift rate hikes being implemented significantly raise the potential for a recession. Recessions are bad for banks on two fronts. First, financially strapped customers may stop paying their loans off, resulting in an increase in delinquencies. And, second, if the economy is iffy, it's likely that loan volume will decline. So, a recession could be a notable headwind for banks. On this front, it is worth noting that there have already been two consecutive quarters of negative gross domestic product in the United States, which some consider the defining characteristic of a recession.
All this concerning news helps explain why the stocks of Toronto Dominion Bank and Bank of Montreal are trading down roughly 27% from their early 2022 highs. But, if you look a little more closely, these two Canadian banks may actually be the best-prepared banks in North America.
Building a bulwark for hard times
The Canadian banking system is very conservative thanks to a strict regulatory regime. For example, during the Great Recession, Canada barred its largest banks from increasing their dividends. That, effectively, forced them to preserve cash. While many large U.S. banks ended up cutting dividend rates, the big Canadian banks didn't have to resort to such a dramatic and worrying action. And, now that the 2007-09 financial panic is well behind the world, Canadian banks are again increasing dividends.
Right now, as the world faces another recession, Toronto-Dominion and Bank of Montreal have taken pre-emptive steps, positioning themselves conservatively so they can weather whatever storm might arise. The key metric to look at here is the Tier 1 capital ratio. This number shows how well prepared a bank is for hard times, with higher numbers being better. Bank of Montreal has a Tier 1 Ratio of 15.8% and Toronto-Dominion has a ratio of 14.9%. Those are the two highest Tier 1 ratios in North America.
To put that a different way, these two Canadian banking giants are better prepared than any other North American bank for a recession.
Meanwhile, the big stock price drops have pushed their yields up to very attractive levels. Toronto-Dominion's dividend yield is currently around 4.4% while Bank of Montreal's yield comes in at an even more attractive 4.7%. For comparison, Citibank, which has an attractive 4.6% yield, has a Tier 1 ratio of 11.9% and Bank of America has a 2.7% yield and a 10.5% Tier 1 ratio. Neither of those risk/reward combinations is nearly as good.
These banks are ready for the storm
Having a high Tier 1 capital ratio doesn't mean Toronto-Dominion or Bank of Montreal will go unscathed if there's a recession. They will feel the hit, just like every other bank in North America. However, they have clearly taken a proactive approach to protect their businesses. Add in the generous yields, thanks to stock selling by worried short-term investors, and now could be a good time for income investors that think in decades, and not days, to initiate a position in one or both of these conservatively positioned banks. The fat dividend checks you collect should help you weather an economic downturn while remaining invested for the long term in two banks that clearly know how to survive hard times.
