Canadian Banks: Don’t Invest for Yield Alone

Canadian bank stocks have become extremely tempting with dividend yields at levels that I cant remember. Bank of Montreal had a yield of over 11% yesterday while other banks are yielding in the 7% – 8.5% range.

On the surface, those looking for yield will choose Bank of Montreal. The next question one should ask after looking solely at yield is how safe the dividend is in the future.

Rob Sedran, Bank Analyst at National Bank Financial, discussed the outlook of the Canadian banks on a conference call today. He believes that the dividends are safe for now on all of the banks without any guarantees.

That being said, the dividend payout ratio should be looked at closely to determine how safe a particular companies dividend may be. We can just look at income trusts and how distributions get cut when cash flow or net earnings drop.

Bank of Montreal’s dividend is the highest but their payout ratio is also the highest as 75% of their net earnings right now go to pay dividends on their common shares. This leaves 25% of earnings to grow the business which is not a great use of capital in the long-term.

The other major banks have payout ratios in the 40% – 59% range of forecasted 2009 earnings giving them a greater cushion to maintain their dividend that will allow them to increase their dividends quicker when things turnaround.

What are your thoughts on the Canadian banks? Will they cut their common share dividends or will they maintain them going forward?

Some Positives on US Housing

US Housing starts dropped to their lowest level ever at an annualized rate of 466,000 which would indicate higher levels of unemployment in the construction trade. The doom and gloom of this number has been broadcast over and over in the media although I don’t believe anyone was surprised by the figure.

So what are the positives? National Bank of Canada put out an economic report focusing on the US housing market showing some positive signals indicating a turnaround may happen sooner rather than later.

Housing deflation has persisted for 30 months and average housing prices are down more than 25%. Without getting too technical, housing affordability has come back to long-term equilibrium levels allowing Americans to consider getting back into the market.

Mortgage rates are dropping and sales have been consistent for several months at 4 million units. There are currently 10 million renters in the US earning more than $50,000 per year which is above the income required to qualify for a conventional mortgage. If just 5% of these renters decide to buy, this will have a huge impact on inventory levels.

After peaking at 11 months worth of inventory for sale, inventories have dropped to 8.7 months. Six months worth of inventory is considered equilibrium. Mortgage applications were up 45% this week compared to last. While many of these applications were refinances taking place at lower rates which is also a positive, applications for purchase were up almost 10%.

The US housing market created this mess and it will be the market that leads us out of it.

What are your thoughts? Do you think we are around the corner to a stabilized housing market or are there many months and years of declines ahead of us?

Company Pension Risk – The Perfect Storm

Last year, I touched on the shortfall that corporate and government pensions had in terms of funding future liabilities. National Bank came out with a report on February 10th updating the current situation on corporate plans that I wanted to share with you.

Between market declines in 2008 and lower interest rates creating a higher present value requirement to meet retiree pension payments, the average corporate pension plan in Canada is underfunded by 40%.

Using a 7.5% rate of return, it will take 12 years to bring these plans back to being fully funded. In the past government regulators have allowed companies to take up to 10 years to fund shortfalls and this will probably continue. That being said, pressure on cash flow and dividends for these companies is around the corner, just as revenues and earnings decline substantially.

Companies that have large pension plans relative to their size include CN, CP, Bombardier, Bank of Montreal, Laurentian Bank, CanWest, Quebecor World, Quebecor Inc,  Torstar, and all of the telcos.

Having a large plan doesn’ necessarily mean that they are underfunded as CN, BMO, and Laurentian Bank were all at or near accounting surpluses at the end of 2007.

Looking at companies that appear to have very large pension obligations and pretty large deficits include Bombardier and Air Canada with Air Canada showing a $403 million pension deficit and Bombardier coming at over $1 billion US.

Trust Distributions Under Immense Pressure

Don’t be surprised to see your income trust distribution cut to zero. Forget 2011. Without a distribution, the preferrential tax treatment that a trust provides over a regular corporation doesn’t mean that much.

In an effort to keep balance sheets in order, REIT’s, Oil and Gas Trusts, and to a lesser extent business trusts are cutting distributions to conserve cash. The reason for this is two fold.

One is the economic uncertainty but the other is the uncertainty of being able to renew upcoming mortgages and convertible debt on the balance sheets.

By keeping earnings in the company, they will be able to be in a better position to pay off debt as it matures or be able to renew financing at less onerous terms.

In most cases, don’t buy an income trust based on its current yield as that yield is not particularly safe. Look at their convertible debt before buying their units as the yields are pretty frothy and provide an extra layer of ssecurity over the units.

Better yet, look at corporate bonds that are yielding 7% or more as you could see some capital appreciation along the way.

If you are looking at trusts that most probably have safe distributions, National Bank analysts point to Inter Pipeline with a current yield of 11.42%, Keyera Facilities yielding 11.14%. On the REIT front, Boardwalk REIT at 6.81% or CAP REIT yielding 8.05% are safer bets. On the business front, A & W reported very strong same store sales growth of 7.5% for the last quarter and is now paying 10.70% based on todays closing price of $12.83.

Are you buying trusts right now based on current yields? Your comments are always welcome.

Bond Bubble Revisited

On December 11, 2008, I wrote a post on How to Profit if The Bond Bubble Bursts which you can revisit by clicking here. Since then, long term US Treasury Bonds have increased by more than 1% and indications are that rates will go higher as the government needs to raise several trillions of dollars over the next year and the market is having trouble digesting the vast quantity required.

I had indicated that one way to profit from this would be to buy the Horizon Betapro 30 year US Treasury Bear ETF that trades on the TSV under the symbol HTD. 

This ETF provides 2 times the daily movement up or down of the underlying investment.  Since the last commentary was written on this subject, the ETF has performed well closing today at $15.15, well above its December 11th close of $13.47, a 12.5% return over the last two months.

The 52 week high was over $20 and I wouldn’t be surprised to see it climb back to those levels by the end of the year. What are your thoughts? Do you think long term bond rates in the US will climb or drop close to all time lows?

We Have Been Here Before Revisited

I came across an article that I wanted to share about the current state of the markets. The interesting thing about this article is that it was written in 1974 when the Oil Crisis was taking place and markets dropped significantly and stayed down for about 2 1/2 years.

The article discussed the markets of 1942 and when you read the article, you would swear that it was written today. Perhaps if anything, you can get some comfort in the content. Your thoughts and comments are always greatly appreciated. 

To read the article, please click on the following link here