National Bank of Canada: Sweet Spot In Canadian Mortgage Market

Author’s note: All figures are in Canadian dollars unless otherwise noted

investment work

I have recommended the National Bank of Canada (OTCPK:NTIOF) in the past for its industry-leading dividend growth and total return profile. In which With interest rates rising and the prospect of a 2023 recession, the National Bank is characterized by its geographic focus on Canada’s domestic market. Although domestically focused on the Canadian market, the National Bank has avoided significant exposure to those segments of the Canadian housing market that are most vulnerable to rising interest rates. With 85% of revenue coming from the domestic market, the National Bank will benefit from Canada’s above-average GDP growth in 2023.

company profile

National Bank operates through four primary business segments: Personal and Commercial Banking, Wealth Management, Financial Markets, and US Specialty Finance and International. The National Bank provides personal and commercial banking and investment solutions, as well as securities broking, insurance and wealth management services. As of Q3 2022, National Bank has approximately $700 billion in assets under management or under management and total assets of $387 billion. The National Bank, headquartered in Montreal, is the dominant lender in the province of Quebec. With approximately 2.7 million customers and 460 branches, the bank has a growing presence in other Canadian regions, as well as a growing US and international presence.

With a market capitalization of approximately US$29 billion, the National Bank of Canada is the smallest of the six systemically important banks in Canada. National Bank trades on the Toronto Stock Exchange under the ticker “NA.TO” and over the counter as “NTIOF” with an average daily trading volume of 1.55 million shares.

National Bank shares are down 11% year-to-date and offer a dividend yield of $0.92/quarter. The National Bank’s current yield of 4.25% is above the 5-year average yield of 3.78%.

Current Results

In the last quarter, the National Bank improved its efficiency ratio to 54.1% from 53.0% in the second quarter of 2022. The National Bank continues to have the best return on equity of any Canadian bank. In that most recent quarter, the National Bank delivered a 22% return on equity.

The SNB continues to diversify its geographic base. In 2020, 54% of revenue came from the province of Quebec, Canada’s second largest with a population of around 8 million. As of Q3 2022, expansion into the Atlantic and western Canada has brought that share down to 52%.

Driven by a strong wealth management segment, Morningstar estimates that noninterest income will grow 3% annually over the next several years. Underscoring this growth are assets under management and fee-based revenue, which are up 17% and 22% year over year, respectively. Even as interest rates rose into 2022, the National Bank delivered strong total loan growth of 12.9% year over year.

Less exposed to Canada’s hottest housing markets

At National Bank’s recent Q3 2022 conference call, President and Chief Executive Officer Laurent Ferreira discussed the benefits of National Bank’s geographic focus in the Quebec mortgage market.

Several factors continue to support Canada’s housing market, including strong immigration and unemployment at historic lows. We also expect Quebec’s housing market to be resilient given better relative housing affordability, consumer savings and debt levels in the province.

In the third quarter of 2022, the National Bank reported commercial lending growth of 17% yoy and retail mortgage lending growth of 8% yoy. Much of this growth continues to occur in the bank’s primary market in Quebec, which accounts for 55% of National Bank’s mortgage portfolio. This heavy exposure to the Quebec market limits the National Bank’s exposure to Canada’s most priceless cities, including Vancouver, Victoria and the Greater Toronto Area.

Ontario and British Columbia, home to two of Canada’s hottest real estate markets, account for 65% of the Royal Bank of Canada’s (RY) mortgage portfolio and 74% of the Toronto-Dominion Bank’s (TD) mortgage portfolio. The National Bank’s exposure to BC and Ontario mortgages accounts for just 34% of its mortgage portfolio.

Of course, geography is not the only factor to consider when assessing the credit risk profile in Canada’s housing market. The National Bank tends to have a higher proportion of insured mortgages in its portfolio compared to other Canadian lenders. TD’s residential mortgage portfolio is approximately 22% insured in Q1 22 while RBC’s is 26%. In comparison, the National Bank’s mortgage portfolio is 30% insured. Uninsured mortgages and HELOC in the Greater Toronto and Greater Vancouver areas account for 12% and 3% of National Bank’s total mortgage portfolio, respectively. These two major metro areas represent almost a quarter of Canada’s population and therefore feature more heavily on most Canadian banks’ mortgage books. Additionally, National Bank has maintained a prudent risk profile on these loans, with an average loan-to-value ratio of 44% for both the Vancouver and Toronto housing markets.

Economic Outlook in Canada

I have written often about the stability of Canada’s well-regulated banking system and the strong market position of Canada’s six domestic systemically important banks (D-SIBs). These six (Bank of Montreal (BMO), Royal Bank of Canada, Toronto-Dominion Bank, Canadian Imperial Bank of Commerce (CM), The Bank of Nova Scotia (BNS) and National Bank together account for over 90% of Canada’s revenue established companies are protected from foreign competition by the Bank Act, which created a protected oligopoly in the domestic banking sector. Historically, Canadian banks have used their above-average revenues from domestic retail banking markets to expand into other geographies and equity investment markets .

The Canadian economy is forecast to overtake the US, UK and Eurozone economies by 2023. The National Bank’s domestic focus should favor it over its more geographically diversified peers. The National Bank of Canada derived 85% of its revenue from the Canadian domestic market in 2021. By comparison, Canada’s retail banking segments account for 60% at Royal Bank, 56% at TD Bank, and 44% at Bank of Nova Scotia.

Looking ahead to 2023, Canada still looks attractive compared to other developed markets. According to the OECD’s latest interim forecast, Canada will lag only Australia and South Korea in year-on-year GDP growth. As a net exporter of energy and many materials and commodities, Canada’s economy will be more resilient than other countries in the event of sustained inflation or high energy prices.

The National Bank increased its provision for loan losses from $3 million to $54 million last quarter in anticipation of a slowdown in economic activity. There’s likely more to come as banks across the sector prepare for a possible 2023 recession. While banks will benefit from rising net interest margins, they may experience a slowdown in credit growth in the short to medium term. The National Bank has prepared for an economic downturn by maintaining a solid balance sheet with a CET1 capital ratio of 12.8%, above the comparative average of 12.4%. In addition to being well capitalized, it has maintained a stable trend from rating agencies: Moody’s: Aa3 S&P: A DBRS: AA (LOW) Fitch: AA.

Investor Takeaways

As higher interest rates prevail in developed countries, banks are increasing their loan loss provisions. The prospect of a recession in Canada has weighed on financials stocks, with the S&P/TSX Capped Financials Index down 16% year-to-date. For long-term investors, this is a great opportunity to consider opening or adding to positions in quality dividend stocks such as Canadian banks.

The National Bank’s domestic profile ensures it will benefit from Canada’s projected strong economic growth relative to other OECD economies. The National Bank has less exposure than its peers to Canada’s most priceless real estate markets. Should interest rates continue to rise, the National Bank’s geographic concentration in Quebec will protect it from defaults.

The National Bank continues to deliver strong results and execute on its earnings diversification and efficiency metrics. National Bank’s geographic profile makes it an attractive choice relative to other Canadian financial stocks in the current macroeconomic context.