There's a mixed outlook for banks today, as rising rates mean these vital financial institutions can charge more for the loans they make. But rising rates also increase the chances of a recession, which would likely increase defaults and reduce demand for loans. Fear is winning out, with the shares of Bank of America (BAC -0.13%) and Toronto-Dominion Bank (TD -0.42%) down about 20% and 16%, respectively, in 2022. Is one of them a better buy? Yes.
A quick history lesson
Banks across the board have materially improved their finances since the Great Recession, which was the economic downturn between 2007 and 2009 fueled by excesses in the financial industry. And yet it still pays to examine history to see what happened to bank investors during that exceptionally difficult time. History never repeats itself, but it often rhymes.
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Bank of America, one of the largest banks in the U.S., made a huge cut its dividend at the start of 2009, slashing the quarterly payout from $0.32 per share to just a penny. That's a token payment meant to allow institutional investors with a dividend mandate to keep investing in the stock. The dividend wasn't increased until the second half of 2014.
Toronto-Dominion Bank, or TD Bank for short, and its peers were forced by the conservative Canadian banking regulators to not raise dividends. The bank's quarterly dividend was stuck at CA$0.30 per share for 10 quarters. When regulators allowed TD Bank to hike the dividend again, the bank promptly did so, in early 2011. The dividend has been increased regularly since that point.
If you are a dividend investor, that backstory should make you much happier to own TD Bank.
What about today?
As noted, however, the current situation isn't the same. U.S. banks have come under greater scrutiny and have been forced to be more cautious. The basic goal of that effort is to avoid a repeat, given that there was a very real concern during the Great Recession that some of the most prominent banks would fold (some well-known banks actually did). So how prepared are these two banks for a recession? That's not an idle question, given that the U.S. has now suffered through two consecutive quarters of negative gross domestic product. That's the unofficial measure of a recession.
To see this you can look at the Tier 1 capital ratio, which basically tries to quantify how well a bank can handle adversity. Higher numbers are better. Bank of America's Tier 1 ratio at the end of the third quarter was 11%, up 49 basis points year over year. That's moving in the right direction, but it pales in comparison to TD Bank's 14.9%. It wouldn't be fair to suggest that Bank of America shareholders are again at risk the same kind of dividend cut as in 2009, but TD Bank is in a much better position to deal with an economic soft patch -- just as it did during the Great Recession.
What's even more interesting is that TD Bank's Tier 1 ratio is the second-highest in North America. In other words, there's only one bank better prepared for adversity. Meanwhile, TD Bank is expanding its footprint in Bank of America's home market. Bank of America, however, can't do much to aggressively expand into Canada because of the country's banking regulations. Once again, TD Bank seems to have the edge.
Time for a deep dive
No company is perfect and TD Bank certainly has warts, notably that the Canadian housing market appears more inflated than the U.S. market this time around. However, if you take some time to get to know the Canadian banking giant, you'll probably end up finding it more attractive than Bank of America. And not just because Bank of America's 2.5% dividend yield looks scrawny when compared with TD Bank's roughly 4%. If you believe in safety first, TD Bank has history and its industry-leading Tier 1 ratio on its side.
