You may have heard about a recent report that flags Canada as being at risk of a financial crisis. The Bank for International Settlements’ (BIS) latest Quarterly Review, released on March 6, ranks Canada as second only to China in showing the highest early warnings signs of stress for domestic banking, thanks to our high consumer debt levels.
The report stipulated that a significant downturn would depend on things like rising interest rates and a corresponding inability for consumers to repay their mortgage debt. But it does draw attention to our inflated housing market and our collective personal debt load.
Is Canada at risk?
According to the latest reading of the Teranet-National Bank Home Price Index, prices rose 13% year over year in Canada, driven largely by a 20.9% gain in the Toronto housing market. And prices don’t show signs of stopping.
If you don’t own a house in Toronto, you might be as tired as I am of hearing about skyrocketing real estate value there. But, here in Canada at least, watching real estate prices is a national sport, and housing tends to dominate the headlines.
One of the potential contributors to a financial crisis would be a large, sudden decline for Canada’s housing market. (Maybe good news for those many frustrated home buyers being outbid in today’s hot housing market?)
And if interest rates rise significantly, Canadian borrowers will have the world’s second-highest debt payments after China. Ultimately, elevated debt levels do expose our economy to negative shocks.
Like many investors, you may be wondering: is this Canada’s version of 2008?
I don’t think so.
Canada’s risk-reducing regulatory framework provides investors with protection …
There are some big differences in how housing in Canada is financed and how mortgages are underwritten—something the BIS report didn’t account for. While a housing downturn would have a direct impact on the banks’ portfolio of mortgage loans, prospective credit losses on mortgages would be limited by Canada’s well-structured mortgage market.
Most of the risk sits with the Canada Mortgage and Housing Corporation (government-backed mortgage insurance). What that means, for example, is that if insured riskier mortgage loans default, the Canadian government will cover losses, not Canadian banks.
In addition, business lines of Canadian banks are also broken into three broad categories: retail banking, wholesale banking and wealth management, so they’re not entirely dependent on mortgage lending for their ability to grow, pay dividends or repay debts.
And finally, regulatory changes after the global financial crisis have forced banks to reduce leverage and build significant pools of capital and liquidity to protect against periods of market stress.
… And MD’s active management balances risk with return
From a domestic investment perspective, banks are critically important to Canadians and their ability to meet their financial goals. The Diversified Banks sub-industry (for example Bank of Montreal, TD Bank etc.) makes almost a quarter of Canada’s equity market, and Financials (including banks, insurance companies, financial services and auto finance) make up 11.5% of the domestic investment grade bond universe.
At MD, all of our client portfolios have meaningful exposure to Canadian banks, with significant allocation within both stock and bond components.
For certain equity mandates like MDPIM Dividend Pool and MD Dividend Growth Fund, we target a high dividend yield, so we have a larger exposure to the income production of domestic bank stocks. This allows us to generate a higher portion of total return from tax-advantaged dividend income, as opposed to capital gains.
Our fixed-income funds and pools, including MD Stable Income Fund, have a higher allocation to bank debt, allowing us to generate more income compared to investments held in Government of Canada or other government issuers. In the event of a housing market correction, we would expect tour active selection of safer available bonds to provide us with greater stability, as it has in past periods of market stress.
Ultimately, we wouldn’t invest in a bank—or buy their debt —if we weren’t confident that we would realize a positive rate of return proportionate to the level of risk.
I’m confident that Canadian banks will be able to continue paying interest on their loans and paying dividends on their shares. As a homeowner, I guess that means I’ll have to keep paying my mortgage. But as an investor, it’s good news.