Canada Has High Household Debt: Are Bank Stocks Safe to Buy?

High household debt in Canada increases the investing risk in big Canadian bank stocks, which now offer higher dividend yields to compensate.

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Canadians woke up to an alarm recently with headlines like the following: “International Monetary Fund (IMF) warns Canada at highest risk of mortgage defaults” from The Financial Post on June 6. The article description wrote, “According to a recent study by the Canadian Mortgage and Housing Corporation (CMHC), household debt in Canada is now the highest among G7 countries.” The bulk of that is held in mortgage loans, as noted in the Global News article that’s subsequently referenced.

The Financial Post article went on to say, “A report by credit research firm Equifax Canada … shows that an increasing number of Canadians with a mortgage are missing payments on non-mortgage credit, up 15.7% from the first quarter of 2022, almost double the rise seen in the previous quarter. The numbers suggest people are feeling the pressure of higher mortgage payments and turning to credit cards to cover other expenses.”

Headlines can be scary, but long-term investors can get a larger dividend yield from big Canadian bank stocks in a higher-risk macro environment today.

On May 28, Global News published an article with the headline, “Canada’s banks are guarding against bad loans. What this means for your money.” Two experts in the article concluded that “from a macro perspective, there’s not much cause for concern for the banks themselves, as they’ve put aside more money for loans going bad. But on an individual level, Canadians should take the higher loan loss provisions as a sign that they might need to tighten their belts in the months to come [due to higher interest costs.]”

Canadian banks are higher-risk investments today

Canada’s Big Five Banks increased their loan-loss provisions in the last reported quarter (their fiscal second quarter) in anticipation of more bad loans in a higher-risk and potential recessionary environment. Therefore, investors can buy the Canadian bank stocks for higher dividend yields of about 4.4% to 6.4%.

For reference, the best one-year interest rate for Guaranteed Investment Certificates (GIC) is about 5.2%. If you trust the big banks for long-term income, you can grab Bank of Nova Scotia (TSX:BNS) and Canadian Imperial Bank of Commerce (TSX:CM) shares for the most income among the big banks with yields of north of 6%.

What’s important to note is that taxed at your marginal tax rate, GICs offer interest income that are more heavily taxed, than the eligible dividends paid by the big Canadian bank stocks if the investments are held in non-registered or taxable accounts.

The trailing 12-month payout ratios of Bank of Nova Scotia and CIBC are about 60% and 61%, respectively, the net income available to common shareholders, whereas their normal payout ratios are about 40-50%. While riskier investments in today’s environment, bank stocks could potentially provide long-term price appreciation as well.

Investor takeaway

The big Canadian banks have been profitable through economic cycles. It is the normal course of action for them to raise their loan loss provisions during times of higher risk in the economy, such as during recessions, which, in turn, weighs on their earnings. Subsequently, when the economy improves, they can release those provisions, which would, in turn, raise their earnings.

If you’re really worried, investigate the big Canadian bank stocks that don’t offer the highest dividend yields, as it suggests they could be more defensive. Furthermore, build a diversified portfolio to spread your risk around.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng has positions in Bank Of Nova Scotia and Canadian Imperial Bank of Commerce. The Motley Fool recommends Bank Of Nova Scotia. The Motley Fool has a disclosure policy.

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