Canada’s largest banks are trading near record highs after a stellar rally in the past year. Investors who missed the rebound are wondering if Canadian bank stocks might still be attractive and good to buy for a self-directed Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) portfolio.
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Outlook for Canadian banks
Strict capital rules and limited competition have enabled the large Canadian banks to navigate through global financial upheavals and economic downturns. Critics complain that the lack of competition enables the banks to charge higher service fees and offer loans at elevated lending rates. This might be the case, but the system also ensures the banking sector is sound, which is essential when the financial world hits a rough patch. Over the long run, the big Canadian banks have always bounced back from difficult times. That will likely continue to be the case, so they deserve to be core holdings in a diversified portfolio.
Risks
The sharp increase in interest rates in 2022 and 2023 drove up borrowing costs for households and businesses. Rate cuts have since eased the pain, but bond yields remain elevated, and that’s what largely determines the rates that are offered on fixed-rate mortgages.
Investors previously worried the banks would see a wave of mortgage defaults in 2025 and 2026 as people with mortgages taken out at very low rates in 2020 or 2021 renew at higher rates. So far, the situation has been net positive for the banks. As long as households still have the same income stream and have built up some home equity, the banks simply allow borrowers to stretch out their amortization, which helps offset the higher borrowing cost on the renewal. This enables people to stay in their homes, and the banks generate more interest income.
The absence of the feared default wave doesn’t mean the banks are immune to risks. In Canada, the housing market has been a great driver of revenue and profit growth for the Canadian banks over most of the past three decades, as steadily rising house prices and strong economic conditions led to larger mortgage loans. All sectors go through cycles, and housing might be headed into a period where there are going to be some tough times.
A severe recession that drives up unemployment would lead to lower loan growth and higher loan defaults. House prices are now pulling back and could fall to the point where people owe more than the house is worth when they have to renew their mortgages. This scenario, when combined with elevated bond yields, would be problematic for the banks, as it limits options to help borrowers navigate the challenges.
Opportunity
Dividend investors who are looking to add a bank to their portfolio might want to consider Bank of Nova Scotia (TSX:BNS). The stock is up 35% in the past six months, but still offers a 4.2% dividend yield.
Bank of Nova Scotia is making good progress on its strategy transition that will see the bank invest more growth capital in the United States and Canada, while pivoting away from Latin America, where much of the investment occurred over the past three decades. Bank of Nova Scotia’s return on equity (ROE) improved last year. As ROE rises, the market should be more comfortable bumping up the price-to-earnings multiple.
The bottom line
Near-term volatility should be expected, given the stellar run in recent months and the potential headwinds, so I wouldn’t back up the truck right now. That being said, any material pullback in the big Canadian banks would be an opportunity to add the names to a diversified portfolio focused on dividends and long-term total returns.
