Benefit from Rising Interest Rates with the Big 5 Canadian Banks

This is a guest contribution by Nick McCullum of Sure Dividend. Sure Dividend uses The 8 Rules of Dividend Investing to identify high-quality dividend stocks suitable for long-term investment.

The Big 5 Canadian banks offer great dividends and the stocks look poised for steady long-term growth if interest rates continue to go higher.

This article will discuss:

  • why we think interest rates in North America are going higher,
  • 5 actionable investment ideas that allow investors to benefit from rising interest rates, and
  • why the banks will benefit from rising interest rates

Interest Rates Are Heading Higher

In both Canada and the United States, the trend is clear: interest rates are on their way up after a prolonged period at near-zero benchmark rates.

In July, the Bank of Canada raised its benchmark interest for the first time since 2010. While the bank did not communicate any concrete plans for future rate hikes, it is likely that more are coming.

Graph of Bank of Canada Overnight Money Market Financing Rate from 1975-2017

Source: YCharts

In the United States, the trend is even more clear.

The U.S. Federal Reserve has increased its benchmark interest rate three times since the financial crisis:

  • December 2015
  • December 2016
  • March 2017

Further, the Fed has verbally communicated that it tends to increase rates two additional times before the end of 2017 (although one may be more likely).

Steady rate hikes have resulted in a noticeable uptick in the effective Federal Funds rate, which can be seen below.

Graph of U.S. Effective Federal Funds Rate from 1954-2017

Source: YCharts

The evidence is overwhelming – interest rates are on the rise, both in the U.S. and in Canada.

So how can investors benefit from this trend?

Royal Bank of Canada (RBC)

Royal Bank of Canada (TSX:RY)(NYSE:RY) is the largest financial institution in Canada with a market capitalization of CAD$134.8 billion.

The bank is one of the top 15 largest global banks and serves more than 16 million clients from its 80,000+ employee base.

RBC business overview Q2 2017

Source: RBC Q2 Investor Presentation – Slide 4

 

Photo: Francisco Diez. License: CC

RBC has a very geographically diversified business model. Over the last twelve months, 61% of the bank’s revenue was generated in Canada, 23% was generated in the United States, and the remainder was generated in various international markets.

This makes RBC well-positioned to benefit from rising interest rates on either side of the border.

RBC also has appeal for dividend growth investors, as the bank currently yields 3.7% and regularly increases its payout to shareholders.

Toronto-Dominion Bank (TD)

Toronto-Dominion Bank (TSX:TD)(NYSE:TD) is Canada’s second-largest bank and has a market capitalization of CAD$117.2 billion.

TD has an extensive presence in the United States. More than half its total deposit base comes from U.S. customers, and TD currently has more retail branches in the United States than in its home country of Canada.

TD Bank business overview Q2 2017

Source: TD Bank Q2 Investor Presentation, Slide 3

TD’s strong and growing U.S. banking presence make it attractive for investors looking to benefit from increases in the Federal Reserve’s benchmark interest rate.

TD is also a solid choice for dividend growth investors. The bank currently yields 3.6% and, like the other Canadian banks, is a consistent dividend grower.

However, TD has one of the lower yields on this list. Investors looking for current dividend yield would be better off considering one of the other high-yield alternatives (perhaps CIBC).

Bank of Nova Scotia logo

Bank of Nova Scotia (BNS)

Bank of Nova Scotia (TSX:BNS)(NYSE:BNS) is Canada’s third-largest financial institution with a market capitalization of CAD$92.1 billion.

What stands out about the Bank of Nova Scotia is its significant international diversification.

Unlike the bank’s peers, the Bank of Nova Scotia does not have a presence in the United States. The bank prefers to invest in emerging markets, particularly its Pacific Alliance countries: Mexico, Chile, Columbia, and Peru.

Importantly, this strategy allows the bank to benefit from a much more favorable interest rate environment. In the most recent quarter, the bank realized 5.00% net interest margin in its international banking segment, nearly double the margin earned in its Canadian operations.

Additional details about the Bank of Nova Scotia’s International Banking segment can be seen below. Financial figures are for the second quarter of 2017.

BNS's International business Q2 2017

Source: BNS Q2 Investor Presentation, slide 9

While the Bank of Nova Scotia’s international focus has been successful so far, it makes this bank a poor choice for investors looking for a pure play on rising domestic interest rates.

With that said, the bank’s 3.9% dividend yield and strong dividend growth prospects make it suitable for a wide number of other dividend growth investors.

Bank of Montreal (BMO)

Bank of Montreal (TSX:BMO)(NYSE:BMO) is Canada’s fourth-largest bank with a market capitalization of $59.6 billion.

Like RBC and TD, BMO has a significant presence in the United States.

BMO Q2 2017 results

Source: BMO Q2 Earnings Presentation, Slide 11

While BMO’s U.S. segment is the one of the top three largest among the Big 5 Canadian banks (along with TD and RBC), it is still dwarfed by the size of its Canadian retail banking segment.

For context, the most recent quarter saw BMO’s U.S. Personal & Commercial Banking segment report $194 million in adjusted net income, which is not even half of the $531 million reported by the Canadian Personal & Commercial Banking segment.

With that said, BMO’s presence in both countries allows its investors to benefit from rising rates at each of the two major North American central banks. The company’s 3.8% dividend yield and robust growth prospects are two other reasons why this stock might appeal to dividend investors.

Canadian Imperial Bank of Commerce (CM)

Canadian Imperial Bank of Commerce (TSX:CM)(NYSE:CM) – or CIBC for short – is the smallest of the Big 5 Canadian banks, with a market capitalization of $46.3 billion.

And, until recently, CIBC was the only major Canadian financial institution without a presence in the United States.

The bank rectified this recently with its acquisition of Chicago-based PrivateBancorp (PVTB), which operates as The Private Bank.CIBC PrivateBancorp Acquisition

Source: CIBC Q2 Earnings Presentation, Slide 5

CIBC’s acquisition of PrivateBancorp closed on June 23. The acquisition is expected to incur total transaction and integration costs of $130-$150 million, and to be fully accretive in Year 3 post-close.

While 3 years is a relatively long amount of time to wait to see the benefits of an acquisition, this was an important strategic move for CIBC. The bank now has exposure to the important United States economy, giving it a long growth runway moving forward.

It also allows CIBC to benefit from rising rates at the Federal Reserve, not just at the Bank of Canada. However, CIBC still has a smaller U.S. presence than many of its peers.

High-yield investors can likely overlook this, though, as CIBC has the highest dividend yield (4.7%) of any of the Canadian banks. This makes CIBC an excellent choice for investors seeking current income.

Why Do These Stocks Benefit From Rising Rates?

The ability for banks to make more money when interest rates rise is the result of their borrowing-dependent business models.

Banks ‘borrow’ the money that is deposited by their customers, and lend this money to other consumers in the form of loans or lines of credit. The banks have some control over the interest rates that these borrowings are financed at.

Accordingly, when interest rates rise, banks can fix their deposit rates constant (temporarily) and raise their lending rates, resulting in a higher net interest margin (which is the difference between the money banks pay on deposits and the money that banks earn on loans).

This following diagram displays this trend for a hypothetical bank operating in a rising interest rate environment.

Example of Net Interest Margin trend of a Bank in a Rising Interest Rate Environment

Source: Author

The space between the green and black lines can be thought of as the bank’s net interest margin. Clearly, net interest margin (and, consequently, interest income) will increase as interest rates rise.

Because of competitive forces, deposit interest rates will eventually rise. However, increases in deposit rates tend to lag increases in lending rates, which boosts net interest margins and benefits the profitability of financial institutions and – importantly – their shareholders.

Final Thoughts

The Canadian banks present an attractive opportunity to benefit from rising interest rates in both the United States and Canada.

However, some of these businesses have more geographically diversified business models than others.

For a pure play on rising domestic interest rates, RBC, TD, and BMO are likely the best bets. If benefiting from rising rates is not your primary goal, a diversified basket of these stocks is likely to do well over the long run – each is attractively valued relative to earnings at current prices.

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Disclosure: At the time of writing, Nick owns shares of the Big 5 banks.

Disclaimer: I am not a certified financial advisor. This article is for educational purposes, so consult a financial advisor and or tax professional if necessary before making any investment decisions.

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