The banking sector has not been a particularly rewarding arena for investors so far in 2023. For example, the Invesco KBW Bank ETF is trading down around 19% so far this year.
By that standard, Bank of America (BAC -0.21%) has done relatively well, with a stock price decline of "just" 14% or so. But there's more to consider here if you are looking to buy bank stocks during the current industry turmoil.
Not so good
There are very real reasons for investors to worry about banks today. While the two most prominent bank failures so far in 2023 were tied to highly specific (and, in hindsight, flawed) business models, the rising interest rate environment increased risk across the industry.
Part of the problem stems from the way bank balance sheets are structured. To vastly simplify things, there are two ways to classify bond investments: one in which the value of the bond gets updated each quarter, and the other where the bond is carried at face value because it is expected to be held to maturity.
Bond prices and interest rates move in opposite directions, so the rising-rate environment has reduced the value of bonds that banks own. Such changes won't be reflected if the bonds are expected to be held to maturity.
As long as a bank doesn't sell those bonds before maturity, there's no problem. But if customers pull cash out in droves and those bonds have to be sold to cover the outflows, there's a big problem. Suddenly, the losses on bonds expected to be held to maturity have to be recognized. Or, to put it another way, the money the bank said was there really wasn't -- a key reason behind the recent bank collapses.
Bank of America doesn't appear to be at risk of going down that path (though it certainly has held-to-maturity assets on its balance sheet), but investors are throwing the baby out with the bathwater in the banking sector at the moment. For instance, if you had invested $1,000 in Bank of America at the start of the year, it would be worth just $860. That's better than a similar investment in Invesco KBW Bank ETF, which would be worth just about $810, but that's not exactly a huge comfort. What should interest long-term investors is that $1,000 invested in Toronto-Dominion Bank (TD 0.46%) would be worth $925.
Safety first
Bank of America is not a bad bank, but there's an important difference between it and TD Bank, as Toronto-Dominion is more commonly called. And that's the Canadian government, which highly regulates the Canadian banking industry and has a very conservative bias.
That bias generally translates to the major Canadian banks (of which TD Bank is one) being highly focused on safety. This is on display today, as investors clearly don't believe there's as much risk based on the performance differences.
U.S. banking doesn't have the same level of regulation, which is why large Canadian banks like TD Bank are expanding south of the border. But they are generally taking their play-it-safe ethos with them. This is why long-term dividend investors should be looking at banks like TD Bank today as an alternative way to invest in the banking sector. But how has this conservative approach translated over time?
An investment in TD Bank over Bank of America would have resulted in a higher return over the trailing one-, three-, and five-year periods. Notice in the three- and five-year comparisons above that it is the most recent downturn where performance diverges most notably. Essentially, when risk in the industry increased, investors stuck with the more conservative bank.
And yet Bank of America trounced TD Bank over the trailing 10 years, turning a $1,000 investment into $2,340, while the same amount at TD Bank only increased to roughly $1,490.
So does this mean Bank of America is the better long-term investment? The time period here matters because it comes after the Great Recession, a period during which Bank of America's stock collapsed, and it had to cut its dividend to a mere token. TD Bank was able to hold its dividend steady, and its stock price held up much better.
If you pull the graph back to the start of 2007, before the recession during that difficult period started, the numbers are drastically different.
If you had invested $1,000 in Bank of America at that point, it would only be worth around $530 today, while the same amount invested in TD Bank would be worth $2,000. To be fair, Bank of America is not the same bank it was back then, but it seems pretty clear that TD Bank's conservative approach has paid off handsomely for investors over time -- and, arguably, exactly when it was most important.
Dislocation opportunities
Would buying Bank of America (with its dividend yielding roughly 3.1%) be a massive mistake in the current banking upheaval? Probably not. However, if you are looking to live off of the income your dividend portfolio creates, it might make sense to err on the side of caution and look at TD Bank (yielding 4.8%), or some of its Canadian brethren, over U.S. banks. They may not have suffered as large a drawdown as their U.S. peers, but that, in the end, may be the biggest selling point.
