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Debunking the 2 Biggest Myths About Buying Toronto-Dominion Bank

Looking at data on Canada’s most shorted names is always surprising. The top of the list is not (and has not been) populated by oil and gas names or even by other commodity-focused names. Instead, Canadian banks feature heavily among the most shorted Canadian names with Toronto-Dominion Bank (TSX:TD)(NYSE:TD) being the most heavily shorted stock in Canada.

Of course, Canadian banks lead the TSX in terms of market cap, so it is expected that they would have more shares shorted than smaller-cap names. What is interesting, however, is that TD leads the banks in terms of short position size by a large margin (over double RBC), despite the fact that RBC has a higher market cap than TD.

The largest sources of anxiety around TD (and banks in general) are worries about the effect of oil prices on credit quality and a potential bubble in Canadian real estate that could result in heavy stress to bank balance sheets. While both of these factors are certainly headwinds, the idea that they will have a severe effect on bank earnings is largely a myth.

TD is well protected from any real estate crisis

There is little doubt that real estate appreciation in Canada is cause for concern, especially in Toronto, Vancouver, and other areas of Ontario. In March, Vancouver saw housing prices skyrocket 22% year over year, and Toronto saw prices skyrocket 15% year over year.

These two markets have seen a massive boost in their growth rates since the Bank of Canada cut interest rates in January from between 5% and 10% annually to well into the double-digit range. This follows a decade of massive growth.

Even if Canadian housing prices were to fall dramatically (many argue for a soft landing, however), TD should be well protected. Canadian regulations provide the first layer of protection; mortgage applicants need to make sure their debt payments will be less than 32% of income in order to be approved. This means most Canadian mortgages are prime.

Secondly, Canadian banks like TD have recourse. If a home price falls below the value of the loan, the borrower must still pay the difference, reducing the odds of a write-down for the bank. In addition, Canadian mortgages with a loan-to-value ratio of 80% or more (the loan is more than 80% of the home value) must be insured. This means TD is protected from the highest-risk loans.

Currently, TD only has 13.6% of its Ontario and B.C mortgages uninsured (compared to 20% for RBC). Of this that is at risk, the loan-to-value ratio is 68%, which means home prices would need to drop over 30% before there are issues.

Oil prices will have little effect on TD

While oil prices are a worry for investors, prices are now increasing; consensus among analysts is that the general trend for oil is now up. This reduces the risk of any oil-related issues for the bank, but even if oil were to stay in the sub-US$40-per-barrel range, TD would have been fine.

In fact, the bank estimated that in the event that oil prices remained in the US$35 range, it would only result in the bank’s provision for credit losses (or how much the bank needs to charge against its earnings to cover expected losses) to increase by 5-10% annually.

TD has a very small percentage of its loans to the oil and gas sector (only about 1%), and the bank also has low exposure to Albertan consumer loans. In addition to this, low oil benefits TD in many ways. TD has large Ontario and U.S. exposure, and both of these regions benefit from low oil prices. The weakness in the Canadian dollar that comes from low oil prices also boosts TD’s U.S. dollar earnings.

While another down-leg in oil prices is certainly a headwind for TD, the effect on TD’s earnings should be low.

Look beyond the banks for dividend income

There's no doubt banks like TD are (and will continue to be) excellent dividend payers. There is an option, however, that could be even better : real estate investment trusts (REITs) allow investors like us to purchase shares in a diversified portfolio of properties and earn a share of the profits. This is like being a landlord without the hassle (and expense!) of dealing with tenants.

Want to know more? Our just-released report, "Earn $6,000 Per Year in Rental Income Without Becoming a Landlord" has all the details. Just click here now to find out how to get your FREE copy today!

Fool contributor Adam Mancini has no position in any stocks mentioned.

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