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The world’s soundest banking system has rarely been so undervalued by investors. As of Oct. 31, the average dividend yield on the Big Five Canadian banks stood at 5.2%, way above the 3.7% yield on 10-year Canadian government bonds. It’s not often bank dividend yields exceed the 10-year government bond yield by such a wide margin.

But with the tsunami of a global commodity bust and severe U.S. recession headed their way, Canadian bank stocks might get knocked down even deeper into bargain territory. Cheaper share prices and richer yields may be the likely consequence of higher loan-loss provisions, slower growth in loan volumes, and declines in market-sensitive business.

An Oct. 31 update on the banking sector by eResearch projects loan-loss provisions for fiscal 2009 of $9.6 billion, double the estimated level for fiscal 2008 (versus a previously projected 30% increase by eResearch). Business-loan losses will contribute nearly half of the jump, while consumer and credit-card loan losses will contribute the other half.

Loan volume growth in Canada was revised down to 2% to 5% for fiscal 2009, compared to “three year annual growth rates of 10% for mortgage and consumer loans and 15% for credit card loans.” The report is also factoring in a 15% decline in revenues from the “market-sensitive” business lines of investment banking, retail brokerage, and trading commissions (which have risen from 19% of total revenues in 2002 to 25% in 2008).

So are the dividends safe? “Yes!” exclaims the eResearch report. Dividend payout ratios currently average 45.8%. The declines in earnings per share projected to fiscal 2009 should raise the average payout ratio to 52%.

While there likely will not be any dividend cuts, there likely won’t be any dividend hikes either in 2009. The average payout ratio of 52% for fiscal 2008 is slightly above the upper boundary for the banks’ payout targets. Royal Bank and TD will still be inside their target range, and so may still have room to increase dividends. Bank of Montreal, with a projected payout ratio of 67% in fiscal 2009, is least likely.

The decline in the Canadian dollar will help offset some of the impact of the commodity bust and U.S. recession, especially for Royal Bank, TD Bank, and Bank of Nova Scotia (because of their foreign operations). Canadian banks also appear to be benefiting from the financial crisis by winning deposits and accounts as clients flee U.S. banks.

The investor’s strategy may be to establish or raise a position in stages, looking for opportunities to buy on the dips when bad news hits share prices. There is a good chance by the end of 2009 that an investor could have four or five of the banks in their portfolio with an average dividend yield geater than 6% – and poised to resume growth at the banks’ historic average rate of 5% to 7% per year.

Bank dividend yields (Oct. 31) 

Royal Bank (NYSE:RY) 4.3%

TD Bank (NYSE:TD) 4.1%

Bank of Nova Scotia (NYSE:BNS) 4.8%

Bank of Montreal (NYSE:BMO) 6.5%

CIBC 6.3%

Source: Canadian Banks Benefit From Market Turmoil