There’s been a remarkable change in the relationship between the attractive dividend yields of domestic banks and the yields on risk-free bonds in the past two decades, and it’s one that implies strong returns for the bank sector in the coming years.
Before the financial crisis, the average dividend yield for the Big Five Canadian banks was well below the five-year government of Canada bond yield. In general, investors were content to accept the smaller income payments in the (eventually correct) belief that stock price appreciation would at least compensate for the difference. This pattern is clear from the first accompanying chart below.
November, 2007, was the last month that bond yields were above bank dividend yields. The change was a function of both the plunging bank stock prices during the crisis – this improved the dividend per share price ratio, if painfully – and Bank of Canada rate cuts that pushed bond yields lower.
Crisis-related anxiety for investors has abated in the past decade, but bank dividend yields have remained well above bond yields – the exact opposite of the pre-2007 trend. Bank stocks have also been cheaper in terms of price-to-book-value. Before the financial crisis, the S&P/TSX banks index traded near 2.5 times book value on average, and it has traded at roughly 1.9 times since.
Market conditions have changed dramatically since 2007, but the combination of higher relative dividend yields and lower valuations makes it easy to infer that domestic investors, rightly or wrongly, have far less faith in the growth prospects for the major banks than before.
The good news is that the relative yields on Canadian bank stocks have been a good predictor of future returns for the major bank stocks over the past decade. Specifically, the average bank yield minus the five-year bond yield has been highly correlated with bank stock returns in the following two years.
The second chart shows how this has worked. The blue line represents relative yields – the average yield on the five bank stocks minus the bond yield. A rising line indicates bank stock dividends increasing in comparison with bond yields. The purple line plots the average performance for the large bank stocks in the 24 months afterward.
For instance, the first data point for relative yields is from February, 2009. At that point, bank dividends averaged 7.6 per cent and the bond yielded 2.1 per cent, making the difference 5.5 per cent – the number plotted on the chart.
The first data point for forward returns – the purple line – shows 104 per cent. This means that the major banks stocks rose 104 per cent on average in the next two years, from February, 2009, to February, 2011.
Yields suggest gains are ahead
for Canadian banks
12
Five-year government of
Canada bond yield
10
Average yield of Canada’s
Big Five banks
8
6
4
2
0
2007
1999
2019
2011
1991
2003
1995
2015
120%
10%
Big Five: Average forward
two-year return
9
100
8
Dividend yield spread:
Average bank yield
minus five-year government
of Canada yield (right scale)
80
7
6
60
5
40
4
3
20
2
0
1
-20
0
2017
2009
2019
2011
2013
2015
THE GLOBE AND MAIL, SOURCE:
SCOTT BARLOW; BLOOMBERG
Yields suggest gains are ahead
for Canadian banks
12
Five-year government of Canada bond yield
Average yield of Canada’s Big Five banks
10
8
6
4
2
0
2007
1999
2019
2011
1991
2003
1995
2015
120%
10%
Big Five: Average forward
two-year return
9
100
8
Dividend yield spread:
Average bank yield
minus five-year government
of Canada yield (right scale)
80
7
6
60
5
40
4
3
20
2
0
1
-20
0
2017
2019
2009
2011
2013
2015
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
Yields suggest gains are ahead for Canadian banks
12
Five-year government of Canada bond yield
Average yield of Canada’s Big Five banks
10
8
6
4
2
0
2007
1999
2019
1991
2011
2003
1995
2015
Big Five: Average forward two-year return
120%
10%
Dividend yield spread: Average bank yield
minus five-year government of Canada yield (right scale)
9
100
8
80
7
6
60
5
40
4
3
20
2
0
1
-20
0
2017
2019
2009
2011
2013
2015
THE GLOBE AND MAIL, SOURCE: SCOTT BARLOW; BLOOMBERG
The two lines on the chart have moved roughly together (the relationship is supported by correlation calculations) indicating that dividend yields have been a successful indicator of future price returns of bank stocks – the higher the average bank dividend relative to bonds, the better the stock performance in the next 24 months.
The average bank dividend yield is currently 2.8 per cent above five-year bond yields. If previous patterns persist, this implies a cumulative average bank stock return of about 20 per cent for the next two years (9.5 per cent annually). The projections are for simple returns, not including dividend payments.
The analysis above is limited in scope – there are obviously many factors beyond yields that determine bank stock returns. Nonetheless, dividend yields have proved an important predictor of future stock returns and, in a yield-starved market environment, this should remain the case.
Scott Barlow, Globe Investor’s in-house market strategist, writes exclusively for our subscribers at Inside the Market.
Scott Barlow