In December the U.S. Federal Reserve made the encouraging move of hiking the key benchmark interest rate by 0.25%. This is after seven years where the rate was held near 0% and over a decade since the last interest rate increase in 2006.
You may be wondering, what does this have to do with Canada or Canadian stocks? Canadian interest rates, after all, have been on a steady decline, with the Bank of Canada suggesting that negative interest rates are even a possibility.
For banks like Toronto-Dominion Bank (TSX:TD)(NYSE:TD), however, the U.S. interest rate matters. With nearly 30% of net income coming from the U.S., rising interest rates mean that TD will see growing net interest margins on its loans after several years of shrinking margins. For TD, the effect of such a small increase can be quite substantial.
TD has been taking action to increase its sensitivity to an interest rate hike
TD has been expecting an interest rate hike from the U.S. for years, and in 2013 it started taking action to make sure its franchise was poised to get the maximum possible benefit from a rise in rates.
As just mentioned, TD benefits from rising interest rates by seeing its net interest income grow—that is to say, the difference between the interest TD receives from its loans and investments and the interest TD pays out to depositors. Rising rates means TD will get more income from loans and investments. Because deposits are usually very short term and the bank lends out and invests in longer time frames, the bank’s interest income will grow at a faster rate than interest expenses when rates rise, leading to a boost in earnings.
In 2013 TD started selling longer-term securities (like U.S. treasuries) and re-invested them in shorter-term securities. By doing this, TD increased its sensitivity to an increase in rates, because the shorter-term securities respond more immediately to an increase in rates. Long-term bonds, for example, would take longer to mature and re-price at the higher rate.
According to National Bank analysts, this strategy dramatically increased the amount of earnings TD would see in the first 12 months after a hypothetical 1% increase in U.S. rates.
TD’s deposit book also positions it to benefit from a rate hike
Currently, TD is in what is known as an “excess deposit” position in the U.S. This means that TD has more deposits than outstanding loans. In Q4 2015 TD had average loans of $126 billion and average deposits of $213 billion.
This means that these excess deposits are often invested in short-term bonds rather than loaned out, which means that TD will once again see an immediate and large increase as a result of short-term rates increasing.
In addition to this, TD will only need to pass a fairly small amount of this increase on to depositors, increasing their leverage to a rate hike. This is partially because a large portion of TD’s deposits are known as “core deposits,” accounts like chequing, savings, and transactional accounts.
Since these types of depositors are less focused on getting the best rate and more focused on day-to-day transactions, the bank needs to pass less of the rate increase on to them to protect their deposit base. This is in contrast to banks that rely more on term deposits or wholesale deposits.
In addition to this, according to National Bank analysts, TD also operates in an environment that is less competitive (the U.S. Northeast), which reduces the amount TD has to pass on to depositors.
How much of an increase will TD see?
Analysts at TD Bank did some calculations to examine how much a 0.25% increase in rates would add to TD’s net income. Overall, TD estimates that a 0.25% increase would add about $120 million to TD’s net income in the first year. Over the course of five years, this would grow to $200 million.
In addition, TD can expect an additional $100 million from TD Ameritrade. Combined, these increases would represent a 2.5% boost to 2015 net income in the first year alone.
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Fool contributor Adam Mancini has no position in any stocks mentioned.