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It's a basic investing principle that has been painfully proven true yet again lately - rising interest rates are bad for those usually imperturbable bank stocks.
Does it follow, then, that banks are the place to be at the end of a rising-rate cycle? Some analysts are doubtful because of concern that a slowing economy would increase losses from bad loans, which today are at historical lows, and because of speculation that bank profit growth could slow. But there's also a good reason to consider bank stocks as a place to invest when interest rates stabilize. Because they've had a somewhat rough go of it in recent days, bank stocks are a bargain by one useful indicator.
It's dividend yield. When a stock's yield is higher than usual, as is the case now with several bank stocks, it tells you that the share price has been beaten down. All you need to remember here is that price of a dividend stock and its yield move in opposite directions. In 2006, rising interest rates have pushed bank stocks lower, which means their dividend yields have been creeping up.
Bank of Montreal is the best example of a bank stock looking attractive on a yield basis. With its shares down about 8 per cent in 2006, BMO shares were yielding a handsome 4.18 per cent at the end of June, which was the best-case return from a one-year bond or guaranteed investment certificate. If you check BMO's yield in previous years, you'll see the current number is quite appealing on a historical basis. Let's take a look back at BMO's yield on its Oct. 31 fiscal year end over the past decade. The last time it approached the current level was Oct. 31, 1996, when it hit 4.17 per cent. More typically, BMO's yield has been in the 2.8 to 3.25 per cent range. Here's how the other Big Five banks look from a yield perspective.
Higher than normal dividend yields are a sign a stock has been falling in price - if you're a smart investor, you'll be wondering about the risk of it falling still further. With bank stocks, and other blue-chip dividend stocks, you have a kind of safety net to protect your shares. Should the price fall to levels where the yield gets out of whack, it's very likely that investors will buy in to take advantage of that yield. Right now, BMO's yield would seem to be approaching that level, given how competitive it is against fixed-income investments, especially on an after-tax basis.
An extra attraction of buying bank stocks when their yields are at a high point is the likelihood that you'll see that yield increase regularly over the years. The reason is that the banks usually raise their quarterly dividends once a year or so, which has the effect of boosting the yield on your invested capital. Over a five-year period, you could easily see your yield increase by a few percentage points.
Bank shares won't necessarily net you a quick payoff if you buy them at a point when interest rates are stabilizing after a period of increases. Remember, the more subdued economic growth that rate increases are intended to bring can mean business difficulties for banks. Still, bank stocks are sending a message right now: with share prices down a bit because of the rate environment, high yields make it a decent time to buy in for the long term.
Rob Carrick has been writing about personal finance, business and economics for more than 12 years.