Canadian bank stocks, including Royal Bank of Canada (TSX:RY) (NYSE:RY), tanked in March and still sit well below their pre-crash highs. Investors now want to know if it is safe to buy the banks.
Bank headwinds
The economic downturn caused by pandemic lockdowns is shaping up to be the worst since the 1930s. Based on the 7.2 million claims for unemployment insurance and the Canada Emergency Relief Benefit (CERB), nearly 30% of COED-identified working-age Canadians say they are earning less than $1,000 per month.
Entering the crisis, Canadian personal debt levels sat near record highs relative to disposable income. Much of the debt is connected to mortgages, including home equity lines of credit. However, credit card debt, car loans, and student loans also factor into the equation.
Given all the potential default risk, you might wonder why anyone would want to own a bank stock today.
Royal Bank of Canada is Canada’s largest bank and the most profitable one. The bank generated adjusted net income of nearly $13 billion in fiscal 2019. Return on equity for fiscal Q1 2020 was above 17%.
Housing risks
The Canadian residential mortgage portfolio was $306 billion as of January 31. Roughly $38 billion is home equity lines of credit. Insured mortgages represented $73.6 billion of the portfolio.
The Canadian government, through CMHC, is buying up to $150 billion in mortgages from the Canadian banks to improve liquidity and help ensure they keep lending.
The banks have provided clients with mortgage deferrals for six months and cut interest rates on credit card balances, thus reducing near-term cash flow and potentially kicking a wave of defaults down the road if the employment situations doesn’t rebound.
It will be interesting to see the fiscal Q2 reports from all the banks to see how much money they are setting aside for credit losses.
Residential mortgages represent 48% of Royal Bank’s loans book. Personal loans account for 14%. Wholesale banking loans, which includes lending between large institutions, covers 34%, while credit cards sit at 2% and small business loans a mere 1% of the overall picture.
Diversification
Canada generates 62% of revenue and the U.S. kicks in 23%. The remaining 15% comes from the other international operations.
Royal Bank has a balanced revenue stream based on business segments. Personal and commercial banking accounts for 49% of profits. Capital markets activities add 22%, while wealth management provides 20%. Insurance contributes 6% and investor and treasury services adds 3%.
The fiscal Q2 results, covering February, March, and April will give investors a sense of which areas are getting hit the hardest by the crisis.
Should you buy Royal Bank of Canada stock now?
Royal Bank entered the downturn with a strong capital position and the measures put in place by the government should help the bank ride out the storm.
In February Royal Bank announced plans to buy back up to 20 million shares over the course of the next 12 months. While that will likely go on hold, the dividend payments should be safe. At the time of writing, investors can pick up a 5% yield.
The stock now trades at $83.50 per share, compared to $109 in February. At this level, most of the pain is probably priced into the shares. That said, prolonged unemployment at current levels is a risk that investors need to consider. If the economy doesn’t open up and start to bounce back by early next year, more pain for bank stocks could be on the way.
Uncertainty remains, but the International Monetary Fund anticipates a strong global economic recovery in 2021. With this outlook in mind, buy-and-hold investors might want to start nibbling on Royal Bank and look to add to the position on additional downside.
