Canadian bank stocks trade below their 12-month highs. Investors who stayed on the sidelines during the sharp rebound from the pandemic market crash are wondering if Royal Bank (TSX:RY) or TD Bank (TSX:TD) is now cheap again and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio.
Bank sector outlook
The failure of three regional banks in the United States earlier this year put bank investors on the defensive. The share prices of American regional banks plunged, as investors worried that more problems could emerge. The negative sentiment drifted north, and most of the large Canadian banks are down from their 2023 highs.
Rising interest rates normally help banks boost their net interest margins. The steep rise in rates over the past year, however, is putting businesses and households with too much variable-rate debt in a difficult position. Large savings built up during the pandemic have helped mitigate the impact, but those funds are drying up, and loan defaults are expected to increase in the coming quarters.
Royal Bank and TD both increased their provision for credit losses (PCL) when they reported fiscal second-quarter (Q2) 2023 results. The PCL number is cash that is set aside to cover potential bad loans and shows up as a hit against earnings. If things turn out to be better than expected and borrowers don’t default, the PCL can be reversed at a later time.
Economists widely expect the economy to go through a mild and short recession late this year or in 2024. High immigration levels and a strong jobs market should put a floor under the Canadian housing market and keep loan defaults in a range that is easy to manage.
Canadian banks are already required to maintain a high level of capital to protect them during a financial crisis, but the government bank regulator is increasing the common equity tier-one (CET1) ratio from 11-11.5% in the coming months to ensure the banks have an even stronger capital base.
This helps protect the banks against problems in the financial system, but it also restricts growth potential by forcing the banks to hold more cash that could otherwise be deployed to generate revenue.
Royal Bank generated $3.8 billion in adjusted net income in fiscal Q2 2023. That was down about 13% from the previous year. the drop is largely due to a PCL of $600 million compared to a PCL reversal in fiscal Q2 2022.
Royal Bank finished the quarter with a CET1 ratio of 13.7%. This will decline once Royal Bank closes its $13.5 billion acquisition of HSBC Canada. It is possible that Royal Bank will move to boost the capital cushion in the coming months to ensure it hits the 11.5% requirement after the deal closes in early 2024.
Royal Bank trades near $126 per share at the time of writing compared to nearly $140 in February. Investors who buy the stock at the current level are not getting a super deal at 12.5 times trailing 12-month earnings, but RY should be a safe buy-and-hold pick, and you can get a 4.25% dividend yield right now.
TD recently ended its plan to buy First Horizon, a U.S. regional bank, for US$13.4 billion. The bank said regulatory challenges forced it to abandon the takeover. Investors might be relieved the deal won’t happen. TD had agreed to buy First Horizon for US$25 per share. First Horizon currently trades near US$11.50.
TD finished fiscal Q2 2023 with a CET1 ratio of 15.3%, so the company has more than enough capital to ride out an economic downturn. The downside of the cancelled deal is the drop in expected revenue and profits. TD had provided guidance for adjusted earnings growth of 7-10% this year. That won’t materialize without the addition of First Horizon.
TD generated fiscal Q2 2023 adjusted net income of $3.75 billion, up slightly from the same period last year. The PCL came in at $599 million compared to $27 million in fiscal Q2 2022.
Another deal could potentially emerge while most bank valuations are low, but management intends to allocate some of the excess capital to grow organically in the American market over the next few years. TD might also give investors a dividend increase or a special one-time bonus payout.
TD stock trades below $83 at the time of writing compared to $93 earlier this year. At roughly 10.5 times trailing 12-month earnings, the stock still looks cheap, even after the recent bounce. The current dividend yield is 4.65%.
Is one a good stock to buy now?
Royal Bank and TD Bank both deserve to be anchor picks in a TFSA or RRSP portfolio. If you only buy one, I would probably go with TD as the first choice today. It is likely the better deal right now for buy-and-hold investors.