- TD Bank's loan book increased by a double-digit percentage, and this also caused the RWA to increase.
- The CET1 Capital also increased but at a much slower pace, and this caused the CET1 ratio to drop.
- The expanded loan book should result in an increased net interest income from this quarter on.
- The dividend should be safe and will be maintained.
- I am holding off on initiating a position until I see how the current quarter evolves.
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Toronto-Dominion Bank (NYSE:TD) (hereafter 'TD Bank') is a major Canadian bank with operations in the USA. Upon reading the bullet points of the bank's Q2 results, I noticed the CET1 ratio fell by a full percent from 12% to 11% compared to a year ago, so I was curious to find out more about this drop and how safe TD's current 5%+ dividend yield is. Other banks like the Bank of Montreal (BMO) (read here) and Laurentian Bank (OTCPK:LRCDF) (read here) also saw their CET1 ratios drop, but not by as much as TD Bank.
The loan loss provisions are in line with the banking income
In the second quarter of the current financial year, TD Bank wasn't immune to the general issue of lower interest income as most banks have been reporting a hit to the interest income. TD saw its interest income drop by approximately C$850M, but, on the other hand, it was able to reduce its interest expenses by C$1.44B, which means the net interest income increased by more than 10% to C$6.46B. Additionally, TD's fee income was roughly C$4.1B, which is lower than in the same quarter last year, but it also means the higher net interest income was a big help in compensating the lower fee income.
Source: quarterly reports
The operating income before loan losses came in at C$4.74B, which is an increase of about 10% compared to the C$4.31B in Q1 last year. So, although the provision for loan losses five-folded to C$3.22B, Toronto-Dominion Bank remained very profitable with a net income of C$1.45B after taking the payments to preferred shareholders into account. Yes, that's less than half the net income of last year, but this is entirely caused by the higher loan loss provisions. Excluding these higher provisions, TD Bank would have shown a much higher net income.
While we can't just ignore the loan loss provisions (which are a necessary evil as long as the total fallout of the COVID-19 outbreak remains uncertain), but the underlying result of TD Bank remained very robust in the second quarter. However, while the equity markets have stabilized the real fall-out from Main Street still has to come, and while banks are proactively working with borrowers to find a solution for temporary payment issues, I do expect the loan loss provisions to remain at an elevated level for the remainder of the year.
The expanded loan book means the amount of RWA goes up - while the CET1 capital doesn't follow
While it was great to see TD Bank still paying a dividend (and has actually increased the dividend by 5 cents), the lower CET1 ratio was what really caught my attention. As of the end of Q2, the CET1 ratio came in at 11%. Still comfortably higher than the 9% required by the OSFI (8% +1%) as TD Bank is deemed to be a G-SIB (Global Systemically Important Bank) which requires the bank to have an additional 1% in CET capital. The 1% is the same requirement as TD's domestic requirement, so the required capital ratio of 9% remained unchanged.
Source: quarterly report
Interestingly, as you can see above, the common equity tier 1 capital increased in the past six months from C$81.9B to C$87.5B and even after taking the adjustments into account, there was a C$2.65B addition to the CET1 capital which came in at almost C$58B as of the end of April.
So, as the CET1 capital increased, the lower CET1 ratio can only have been caused by an increase in the amount of risk-weighted assets. And indeed, compared to six months ago, the amount of RWA totalled C$456B but has now increased to C$524B.
Source: quarterly report
The question we now need to ask ourselves is what caused the bump in the RWA. Has the existing loan book suddenly lost value and are the loans now suddenly riskier? Upon comparing the balance sheet as of the end of April, compared to the end of FY 2019, we noticed the total loan book increased from C$685B to almost C$750B, so the lower CET1 ratio is caused by a larger loan book.
This also will have a delayed positive consequence. By lending more money to its clients (mainly businesses as the amount of residential mortgages increased by less than C$8B), the interest income will increase as well, so I am expecting a bump in the net interest income in Q3. This also means the net income should increase again (although this will depend on the future loan loss provisions from here on) which in turn will allow TD to retain a larger share of its net income after paying a dividend, which will then boost the CET1 capital position and restore the 'old' CET1 ratio.
That obviously won't happen overnight. But I would expect the Q3 results to show a higher net interest income. Assuming the net interest margin will remain stable at 1.9% (1.91% in Q2), the C$65B loan book expansion could easily result in a C$250-300M boost to the net interest income (note this will obviously also depend on the amount of client deposits TD will have to pay interest on).
Keeping all other factors stable, the expanded loan book will add around C$200M in after-tax income which has an immediate impact on the CET1 capital to the tune of 0.15% per year. So, while the lower CET1 ratio creates a bad headline, it will result in an after-tax annual earnings boost of C$800M. Note: once the COVID-19 crisis wears off, I expect companies to repay the loans and cash drawn down from the credit facilities, which will make the loan book shrink again. But it all boils down to this: don't let the 1.1% drop in the CET1 ratio scare you.
I don't have a position in TD Bank yet as I would first like to see how the bank performs in the current quarter as the US-based division may struggle with the high unemployment rate.
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The Investment Doctor is a financial writer, highlighting European small-caps with a 5-7 year investment horizon. He strongly believes a portfolio should consist of a mixture of dividend and growth stocks.He is the leader of the investment group European Small Cap Ideas which offers exclusive access to actionable research on appealing Europe-focused investment opportunities not found elsewhere. The a focus is on high-quality ideas in the small-cap space, with emphasis on capital gains and dividend income for continuous cash flow. Features include: two model portfolios - the European Small Cap Ideas portfolio and the European REIT Portfolio, weekly updates, educational content to learn more about the European investing opportunities, and an active chat room to discuss the latest developments of the portfolio holdings. Learn more.
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