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?

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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.

All I want is 10% Guaranteed!!!

With the markets as volatile as ever, it can be difficult to stomach the ups and downs as you try and have  a portfolio generate enough income or growth to last a lifetime. I know of many clients who talk about the days when they could get 19% on Canada Savings Bonds, 20% or more on Term Deposits, and those lucky few who annuitized and locked in 16% for life.

Of course inflation was running rampant in double digits and with higher tax rates, you were lucky to break even. Over the last year, while the Fed and the Bank of Canada have lowered rates to stimulate the economy and try and avoid recession, rates on corporate debt and preferred shares have gone up significantly. The spreads between bank debt and government debt are the widest they have been in over 20 years.

You could argue that Canadian banks are going to collapse so the risk of investing in a bank guaranteed bond or preferred share is too high. Looking at things objectively, the likelihood of one of our banks going bankrupt and the common share price going to zero are remote.

If you are on the same page as me and believe that a bank failure in Canada is not likely, there is an interesting opportuntiy that awaits. Preferred shares issued by corporations in Canada are eligible for something called the dividend tax credit. Because Canadian corporations have already paid tax on their earnings, the dividends that flow through to individual investors are subject to a reduced level of tax.

As I look at my stock screen today, I see that CIBC and Laurentian Bank have perpetual Preferred shares currently yielding approximately 7.25% per annum with the dividends paid quarterly. So, how do I come up with 10% when they are paying 7.25%. Interest earned on GIC’s is fully taxable. The preferrential tax treatment on dividends and preferred shares equates to just under 10% for a Canadian in the highest marginal tax bracket on an interest equivalent basis.

Some would argue that there are further write downs to come and that interest rates in Canada are going to rise since inflation is going up. I would agree that government bond rates will probably rise over the next 12 months. Nobody knows how much, but, I would argue that while government rates go up, the spread between government and corporate bonds could fall which means that you wont be able to get 8%, 9% or 10% on these preferred shares next year and that this deal will look like the annuity that we should have locked in at 16% for the rest of our lives.

What are your thoughts on interest rates and corporate debt? Your opinions are more than welcome.

Shaw Communications, Precision Drilling, Epcor Preferred Shares

The highlight of today in the Canadian markets on the last trading day of the month, quarter and half of the year is Shaw Communications up 4.20% with a couple of hours left in the trading day. With Shaw (SJR.B), you have an excelleng growth story and steady dividend increases. Shaw reported a 40% increase in profits and an 11% dividend increase. For cash flow investors, you are getting a growing dividend of just under 4% annualized and paid monthly.

Shaw is also anticipated to make a very competitive move by entering into the wireless arena as they have entered into the auction to become a participant.

Updating the takeover play of Grey Wolf by Precision Drilling (PD), Grey Wolf has rejected the third offer of $10.00 still stating that its planned merger is a better long term play for shareholders.

In Fixed Income Markets, there are some interesting buys available as spreads between government debt and corporate debt continue to widen. Epcor Edmonton Power (EPP.PR.A) preferred shares now have a current yield of 7% with preferrential tax treatment for Canadian investors.  Laurentian Bank Preferreds (LB.PR.D) are yielding 6.60%

There are National Bank bonds with a 10 year maturity paying over 6.50% and Royal Bank Capital Trust securities with a 3 year maturinty yielding 5.3%. All of these are interesting buys considering the volatility and long term returns of the general markets.

Your comments relating to the attractiveness of corporate bonds would be greatly appreciated. Have a great Canada Day.