Bank of Nova Scotia (BNS 0.52%), or Scotiabank as it is more commonly called, has a generous 5.8% yield on its dividend. By comparison, fellow Canadian banking giant Toronto-Dominion Bank (TD 1.23%) yield is 4.3%. Why the difference? There's a long-term reason, and it could be a big issue over the near term.
These banks have differing approaches
Canadian banks are conservative by their very nature. Heavy government regulation is largely responsible for this, and for limiting competition to the point where the largest banks have defensible, entrenched positions. Scotiabank is one of the biggest banks in Canada, and that's highly unlikely to change anytime soon.
Image source: Getty Images.
So it wouldn't be fair to suggest that Scotiabank is taking on shocking risks, but it has taken a very different approach than its peers. Most of the large Canadian banks, like TD Bank, have chosen to use their solid Canadian foundations to build out banking businesses in the United States. The U.S. banking market is fragmented and there is generally less regulation, allowing for acquisition-driven growth and organic expansion. Scotiabank has chosen to look further south for its growth, with material banking presences in Mexico, Chile, Peru, and Columbia.
Having exposure to emerging markets is generally expected to result in stronger long-term growth, but also higher volatility when it comes to short-term business performance. So from a dividend investor's point of view, Scotiabank is higher risk than its Canadian peers. Thus, a higher yield makes logical sense as compensation.
Where the money comes from
In addition to the structural difference in the company's geographic profile, it also has a different funding profile. Indeed, the bank's relatively weak fiscal 2023 first-quarter performance (for the quarter ending Jan. 31) highlighted what is, for now at least, the company's Achilles' heel.
At the simplest level, a bank takes in deposits from customers and then uses that cash to make loans. A bank earns the difference between the interest rates it pays for deposits and the interest it charges for loans. In the real world, however, banks don't actually have to take deposits from customers -- they can use what is known as wholesale funding. Essentially, the bank reaches out to non-customers for cash to use to support its loan writing. Such deposits tend to be more costly (carrying higher interest costs) than customer deposits. And wholesale funding interest costs also tend to rise more quickly as market interest rates rise, as they have been over the past year. Scotiabank relies more heavily on wholesale funding than many other banks.
The end result is that Scotiabank's margins have been under pressure, leading to relatively weak performance. For example, it fell short of Wall Street estimates on both the top and bottom lines in the fiscal first quarter of 2023. Management, however, is cognizant of the issue, and is planning to increase its focus on acquiring lower-cost customer deposits over time. This won't be a quick fix, but something is being done about the issue. But while this headwind continues, investors are likely to look negatively on the bank's stock.
A worthwhile risk
With a higher-than-average dividend yield, though, long-term income investors shouldn't ignore Scotiabank. It's worth noting that the bank has paid a dividend since 1833 (that is not a typo), with increases in 43 of the last 45 years. Yes, it has a riskier business model, and the wholesale funding issue is a near-term headwind. But given the dividend history here, it seems like the high yield is an opportunity to own a well-run bank that offers a very unique geographic footprint. In other words, the risk/reward balance seems reasonable, if not downright attractive.
