3 Reasons to Look at Canadian Banks for Income in 2025
By now, it’s well understood that an economic chasm has opened up between the U.S. and Canada. We can see this from incoming data and the corresponding divergence in speeds with which central banks are moving policy rates back to neutral, which is to say, for the Federal Reserve (Fed) is slower and the for Bank of Canada (BoC), faster. The rationale for why this gulf has developed is a topic for a different note. Instead, for investors, what is important is to understand how much of this theme is priced in.
Featured ETFs
- BMO Canadian Bank Income Index ETF (Ticker: ZBI)
- BMO Aggregate Bond Index ETF (Ticker: ZAG)
- BMO Discount Bond Index ETF (Ticker: ZDB)
- BMO Equal Weight Banks Index ETF (Ticker: ZEB)
For instance, let’s look at the bond market. We’ve long been advocates of a higher allocation to CAD fixed income in portfolios – not least as we disagree with the market on how much easing is left for the BoC in the coming years. Indeed, with forward OIS markets are still pricing the BoC administered rate to end up between 2.50-2.75%, but we envisage the terminal rate being closer to 2.00%, meaning there’s more room for CAD fixed income to perform. However, we cannot look past the fact that spreads to U.S. tenors have reached extremes that tell us that this theme feels priced into the sovereign yield curve at this point (see Chart 1). As such, our preference now is to look elsewhere to play the Canada/U.S. divergence theme.
Chart 1 – Z-Score of GoC-UST Spreads (March 2022–Now)
Into 2025, one potential spot to look at are instruments that track CAD spread products. A particular favourite of ours is the BMO Canadian Bank Income Index ETF (Ticker: ZBI). This ETF is designed to provide income via investments in Canadian bank financing instruments – most notably notes, preferred shares (prefs) and limited recourse capital notes (or LRCNs).
Below, we provide three reasons why we should continue to expect to see ZBI outperform going forward.
Reason 1 – It’s Simple…Yield and Duration
Since the dawn of the central bank tightening cycle a few years back, the average level of volatility in sovereign rates has risen. This rise is rooted in several themes, including the re-pricing of long-term inflation expectations and the still-nascent recovery in term premium. Nevertheless, episodic volatility in rates will risk harm to duration-heavy portfolios. As such, instruments that offer attractive yields with shorter duration project better amidst an uncertain backdrop.
In that light, ZBI has a weighted yield-to-maturity (YTM) of 4.32% and duration of 2.11 years.1 For investors looking to add less duration risk and more YTM to their core fixed income holdings such as the BMO Aggregate Bond Index ETF (Ticker: ZAG) or BMO Discount Bond Index ETF (Ticker: ZDB), ZBI can be a great tool to do that.
Chart 2 – Complement Core Fixed Income with ZBI
Reason 2 – We’re talking Canadian banks here…
Traditionally, Canadian banks have been very prudent about capital appreciation. The happy byproduct of that is it means dependable dividends with upside over time. By proxy, that ‘diligence’ to core capital appreciation also extends to other instruments that fall under the same bucket for regulatory capital – that being additional tier 1 (or AT1).
Through ZBI, retail investors have a way to gain access to AT1 issues – which includes prefs, contingent convertibles and LRCNs. Prefs have seniority over common shares when it comes to dividend payouts, but banks have every incentive to ensure that coupon/dividend payments on other AT1 instruments aren’t skipped or cut. Again, that further reinforces the relatively attractive yield offered by ZBI.
Reason 3 – Canadian Banks Are Flush with Capital
The recent round of bank earnings also flagged an important theme –Canadian banks continue to remain flush with capital. For instance, the average CET1 ratio (tier one equity divided by risk-weighted assets) amongst the six “domestic systemically important banks” is now at 13.3% — which is within the range over the past few years. Also, banks have been running total capital well above the regulated ratio of 11.5% (excluding the domestic stability buffer) for years now.2
Of course, this build in regulatory capital was prudent as loans that were originated in a low-interest rate environment came up for renewal and the risks of impairment rose. However, with the BoC now easing rates, banks now have some degree of breathing space when it comes to deployment of that ‘excess’ capital. This could come through loan growth on the asset side of its balance sheet, or in the form of dividends and share buybacks.
Chart 3 – Canadian Bank Capital Ratios Over Time
An additional observation is that banks are well in excess of their total loss absorbing capital (or TLAC) hurdles. Indeed, banks have enough ‘going concern’ (tier one), ‘gone concern’ (tier two) capital alongside other prescribed shares and liabilities (AT1) to meet both the risk-based and leverage-based TLAC ratios stipulated by OSFI. The implication here is that there’s less of a need for banks to raise additional capital or hybrid securities for regulatory purposes. Indeed, beyond a likely extension of retail preferred shares that are due to be called next year, the outlook points to less of a need to issue new AT1 or NVCC.
What does this all mean for ZBI? Well, into 2025, AT1 issuance from banks (either LRCNs or institutional paper) will mostly be about buffer management as risk-weighted assets gyrate. That’s a very different scenario to prior years – when it was about ensuring key hurdles were met. At the margin, this helps ZBI in a few ways.
- First, it means less pressure on current hybrid instruments from additional supply relative to prior years.
- Second, with rates heading lower, the risks to bank funding costs should also be tilted to the downside from here, as well.
- Third, over the long term, there should continue to be a shift away from traditional rate-reset preferred shares, and redemptions should benefit the underlying as well as instruments that track them.
ZBI has performed relatively well this year, but we feel that there’s still more room for outperformance in 2025 for the above reasons. There’s an additional kicker in that ZBI can act as a great complement to a core equity position in something like the BMO Equal Weight Banks Index ETF (Ticker: ZEB) because of its much lower beta to the overall index. This could prove advantageous during periods of volatility – which we expect over the course of the coming year.
Chart 4 – ZEB & ZBI Market Sensitivity
1 As of November 30, 2024.
2 Office of the Superintendent of Financial Institutions, as of November 2024.
Disclaimers:
For Advisor Use Only
The communication is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.
Any statement that necessarily depends on future events may be a forward-looking statement. Forward-looking statements are not guarantees of performance. They involve risks, uncertainties and assumptions. Although such statements are based on assumptions that are believed to be reasonable, there can be no assurance that actual results will not differ materially from expectations. Investors are cautioned not to rely unduly on any forward-looking statements. In connection with any forward-looking statements, investors should carefully consider the areas of risk described in the most recent prospectus.
Third Party Links and Content
This article may contain links to other sites that BMO Global Asset Management does not own or operate. Also, links to sites that BMO Global Asset Management owns or operates may be featured on third party websites on which we advertise, or in instances that we have not endorsed. Links to other websites or references to products, services or publications other than those of BMO Global Asset Management on this do not imply the endorsement or approval of such websites, products, services or publication by BMO global Asset Management. We do not manage, and we are not responsible for, the digital marketing and cookie practices of third parties. The linked websites have separate and independent privacy statements, notices and terms of use, which we recommend you read carefully.
Any content from or links to a third-party website are not reviewed or endorsed by us. You use any external websites or third-party content at your own risk. Accordingly, we disclaim any responsibility for them.
Distribution yields are calculated by using the most recent regular distribution, or expected distribution, (which may be based on income, dividends, return of capital, and option premiums, as applicable) and excluding additional year end distributions, and special reinvested distributions annualized for frequency, divided by current net asset value (NAV). The yield calculation does not include reinvested distributions.
Distributions are not guaranteed, may fluctuate and are subject to change and/or elimination. Distribution rates may change without notice (up or down) depending on market conditions and NAV fluctuations.
The payment of distributions should not be confused with the BMO ETF’s performance, rate of return or yield. If distributions paid by a BMO ETF are greater than the performance of the investment fund, your original investment will shrink. Distributions paid as a result of capital gains realized by a BMO ETF, and income and dividends earned by a BMO ETF, are taxable in your hands in the year they are paid.
Your adjusted cost base will be reduced by the amount of any returns of capital. If your adjusted cost base goes below zero, you will have to pay capital gains tax on the amount below zero.
Cash distributions, if any, on units of a BMO ETF (other than accumulating units or units subject to a distribution reinvestment plan) are expected to be paid primarily out of dividends or distributions, and other income or gains, received by the BMO ETF less the expenses of the BMO ETF, but may also consist of non-taxable amounts including returns of capital, which may be paid in the manager’s sole discretion. To the extent that the expenses of a BMO ETF exceed the income generated by such BMO ETF in any given month, quarter, or year, as the case may be, it is not expected that a monthly, quarterly, or annual distribution will be paid. Distributions, if any, in respect of the accumulating units of BMO Short Corporate Bond Index ETF, BMO Short Federal Bond Index ETF, BMO Short Provincial Bond Index ETF, BMO Ultra Short-Term Bond ETF and BMO Ultra Short-Term US Bond ETF will be automatically reinvested in additional accumulating units of the applicable BMO ETF. Following each distribution, the number of accumulating units of the applicable BMO ETF will be immediately consolidated so that the number of outstanding accumulating units of the applicable BMO ETF will be the same as the number of outstanding accumulating units before the distribution. Non-resident unitholders may have the number of securities reduced due to withholding tax. Certain BMO ETFs have adopted a distribution reinvestment plan, which provides that a unitholder may elect to automatically reinvest all cash distributions paid on units held by that unitholder in additional units of the applicable BMO ETF in accordance with the terms of the distribution reinvestment plan. For further information, see the distribution policy in the BMO ETFs’ prospectus.
Past Performance is not indicative of future results.
BMO Global Asset Management is a brand name that comprises BMO Asset Management Inc. and BMO Investments Inc. No portion of this communication may be reproduced or distributed to clients.
All investments involve risk. The value of an ETF can go down as well as up and you could lose money. The risk of an ETF is rated based on the volatility of the ETF’s returns using the standardized risk classification methodology mandated by the Canadian Securities Administrators. Historical volatility doesn’t tell you how volatile an ETF will be in the future. An ETF with a risk rating of “low” can still lose money. For more information about the risk rating and specific risks that can affect an ETF’s returns, see the BMO ETFs’ prospectus.
This article is for information purposes only. The information contained herein is not, and should not be construed as investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.
BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.
The ETF referred to herein is not sponsored, endorsed, or promoted by MSCI or Bloomberg and they each bear no liability with respect to any such ETF or any index on which such ETF is based. The ETF’s prospectus contains a more detailed description of the limited relationship MSCI or Bloomberg have with the Manager and any related ETF.
Commissions, management fees and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. The indicated rates of return are the historical annual compounded total returns including changes in unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Exchange traded funds are not guaranteed, their values change frequently and past performance may not be repeated.
For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination.
BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal.
BMO Global Asset Management is a brand name under which BMO Asset Management Inc. and BMO Investments Inc. operate.
“BMO (M-bar roundel symbol)” is a registered trademark of Bank of Montreal, used under licence.