Bank of Nova Scotia (BNS -0.11%), more commonly referred to as Scotiabank, is offering a very generous 5.9% dividend yield today. That's more than double what you'd get from Bank of America (BAC 1.53%). Before you jump on board, however, you need to understand a couple of things. Here's why Scotiabank's yield is so high.
Recessions happen
The economy goes in cycles, with expansion invariably followed by recession. During the expansion phase, Wall Street is jubilant and stocks move higher. During the recession phase, stocks generally fall. In some cases, such as consumer staples, the headwinds are more theoretical than real. In others, notably banks, there are very obvious risks to face in an economic downturn.
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With interest rates rising fast as central banks try to combat inflation, investors are fearing the worst. If the rate hikes do lead to a recession, banks like Scotiabank will likely find that their businesses suffer as customers pull back (leading to lower demand for loans). Worse, struggling customers may start to default on their debts. That could lead to write-offs and weak financial results.
This is a key piece of what's weighing on Scotiabank's stock price today. However, this issue isn't unique to Scotiabank -- it's an industry problem. So you can't hold it against Scotiabank. And, with a Tier 1 Capital Ratio of 11.5%, it is in a strong position to deal with any economic headwinds. Higher numbers are better on the Tier 1 ratio, which provides an indication of a bank's capacity to deal with adversity. For context, Bank of America's Tier 1 ratio is 11.2%.
A negative that's a positive?
It probably isn't reasonable to be too negative on Scotiabank as it relates to the very real possibility of a recession in 2023. However, the Canadian bank also has a unique level of exposure to South America. While many of its Canadian peers have chosen to focus on expanding in the U.S. market, Scotiabank believes the faster growth rates in the emerging markets of South America present better long-term growth opportunities.
Countries like Mexico, Chile, Brazil, and Peru, among others, make up around 30% of the bank's business. In recent years it has been refining its exposure to focus on the markets where it believes it has the best prospects and enough scale to compete effectively. But the returns from South America are still below those of the company's Canadian operations. That's a problem that's unique to Scotiabank.
However, if you think long-term, having more exposure to up-and-coming economies is a potential positive. Growth in developed markets like Canada and the United States is modest, but emerging markets are likely to see much more rapid economic expansion over time. Such countries are working from smaller bases, and the economic ups and downs are likely to be more dramatic, but that doesn't change the long-term trend. From a strategic point of view, even if a recession is more painful in the near term for Scotiabank because of this exposure, it has its fingers in markets with more long-term opportunity.
In the end, short-term investors are likely to see the South American exposure as a risk. Investors who think in decades, however, are likely to see it as a growth driver. And remember that Scotiabank has existed for nearly 200 years, so this isn't a fly-by-night operation. It clearly has the staying power to see this investment through.
More risk, more return
Scotiabank is dealing with the typical economic concerns that are affecting all banks today. But investors have an additional concern here regarding the bank's South American exposure. That's not unreasonable, given that emerging markets tend to be more volatile than developed ones. However, if you think in decades and not months, this very same emerging market exposure is a reason to see the high yield today as a long-term buying opportunity.
