Similar to most bank stocks, the Royal Bank of Canada (TSX: RY)(NYSE: RY) got beaten down in the COVID-19 market crash. Faced with increased defaults on mortgages and oil & gas loans, it fell dramatically before staging a partial recovery. For the year, RY remains down 8.5%, but has bounced back considerably from its March lows.
The question now is whether it can keep up the gains and go back to all-time highs. Right now you can buy Royal Bank stock and lock in a 4.5% yield, a solid reason to consider investing. There’s also good reason to believe that RY will see continued gains this year.
While RY stock may not race back to all-time highs overnight, it could see some appreciation if some of its biggest risk factors cool off. And there’s reason to believe that that will happen.
Risk factors slowly abating
One of the biggest reasons the Royal Bank started sliding in March is because the COVID-19 pandemic exposed it to unprecedented risk factors. These included:
- Mortgage defaults
- Defaults on oil & gas loans
- Credit card defaults
These factors led to banks having to increase their Provisions for Credit Losses (PCL). People being laid off exposed banks to the risk of mortgage defaults. The April energy crash posed a serious risk of energy companies defaulting. Finally, out of work consumers increased the likelihood of credit card defaults–Canada’s consumer debt to GDP ratio was already high before COVID-19.
Fortunately, all of these risk factors are gradually diminishing. In June, Canada added nearly a million jobs; the more people go back to work, the less of a risk mortgage and credit card defaults become. Over the summer, the price of oil rose, reducing the risk of defaults on oil & gas loans.
While there’s still a serious risk of borrowers defaulting, the situation isn’t looking as bad as it did in March or April. So banks like RY could be able to lower their PCL in the future. That would result in higher earnings, as the banks’ revenue is actually growing. For example, the Royal Bank’s revenue for the six months ended on April 30th 2020, was higher than for the same period in 2019.
A solid dividend
At current prices, the Royal Bank has a very juicy dividend of 4.5%. In Q2, the payout ratio was unsustainable at 108%, but remember that the risk factors facing banks are beginning to fade. The biggest single factor in RY’s lower earnings in Q2 was an increase in PCL.
If previously risky loan accounts become sound once again, then RY can lower its PCL in the future. That will result in higher earnings and a lower payout ratio. Assuming that recent economic trends continue, RY’s dividend will be safe.
