Big Canadian telecom stocks like TELUS (TSX:T) and big Canadian bank stocks like Toronto-Dominion Bank (TSX:TD) are often held in diversified portfolios for income generation. Which is a better buy for passive income in your Tax-Free Savings Account (TFSA) today?
First, it’s important to note that both dividend stocks have fallen more substantially than the Canadian stock market, using iShares S&P/TSX 60 Index ETF as a proxy, since 2022 when the Bank of Canada began increasing the policy interest rate to curb inflation. The price action is displayed in the graph below.
T, TD, and XIU data by YCharts
Why TELUS stock is down
A podcast posted on the Mawer Investment Management website this month provides an explanation for the weakness in the Canadian telecom stocks, which, among other reasons, are impacted by higher interest rates. It noted that over the past decade or so, the big Canadian telecom companies had exercised quite a bit of pricing power with growth engines from home, internet, mobile penetration or mobile pricing longer term.
However, today, they don’t have the same pricing power. The podcast also mentioned that the telecoms have a lot of debt on their balance sheets and are outspending their cash flow. As well, it pointed out increased regulation that’s encouraging prices to come down or remain stable.
Why TD Bank stock has declined
As Investopedia explains, “the yield curve graphically represents yields on similar bonds across a variety of maturities… A yield curve inverts when long-term interest rates drop below short-term rates… Such an inversion has served as a relatively reliable recession indicator in the modern era.”
Manulife Investment Management noted, “Spurred in large part by the Bank of Canada’s aggressive rate-hiking cycle, the inversion initially happened in July 2022.”
In any case, higher interest rates are making it harder for individuals and businesses to take out loans and service debt. Particularly, it’ll hit individuals or businesses that are under variable interest rates, renewing their loans, or taking out new loans. Consequently, just like its peers, TD Bank has been increasing its loan loss provision to set aside a bigger reserve to prepare for a greater amount of bad loans. This, in turn, is reducing the bank’s near-term earnings.
Dividend and stock valuation
At $22.12 per share, TELUS stock offers a dividend yield of close to 6.6%. On its website, it noted that it plans to increase its dividend by 7-10% per year through 2025. Sure enough, its trailing 12-month (TTM) dividend is 7.3% higher year over year. That said, its TTM free cash flow payout ratio is extended at 134%. At the recent quotation, analysts believe the stock is undervalued by about 21%.
TD stock yields almost 4.9%, at $78.71 per share, which represents a discount of about 15%, according to analysts. Its payout ratio is estimated to be about 63% this fiscal year, primarily from a drop in earnings. It would be interesting to see if it will increase its dividend in December based on its usual schedule or if it will maintain its dividend instead, as during challenging economic times, the regulator might ask the bank and its peers to freeze their dividends and pause stock buybacks to improve the stability of the financial system.
Investor takeaway
Comparing the two stocks is really comparing apples to oranges because they are different businesses in different sectors. That said, the lower dividend yield in TD suggests it could be a safer investment for passive income and total returns. TD also operates in a more supportive regulatory environment. Then again, the market correction is an opportunity to buy the dip for more income generation for the long term. TELUS appears to be finishing up some major investments. So, a jump in free cash flow by 2024 could make its dividend safer.
