Transcript: Insurers are outshining banks in the current high-rate environment

Joe Sirdevan (JS): The current status of the financial service industry is a bit in flux, particularly in the U.S. Evidence of this is the recent run on a few of the regional banks, in particular, Silicon Valley. The situation in Canada is much more stable. As we have said in earlier episodes of Soundbites, the actions of monetary and fiscal authorities during Covid are leading to the outcomes we are seeing today. During Covid, central banks cut rates and dramatically increased money supply. In the last year or so, central banks sharply reversed themselves, and raised rates in an effort to combat the resultant inflation. But these actions are leading to compressing prices for assets such as stocks and fixed-income securities. And it is having real impact on slowing or even halting economic growth. The run on some individual banks in the U.S. is somewhat due to these factors. In the case of Silicon Valley Bank, its deposits ballooned during the speculative period accompanying Covid. It took this very low-cost source of capital and made loans and with the excess invested in bonds. However, when rates started to increase, the bond prices fell. This is generally not a problem if you hold the bonds to maturity. But for reasons specific to SVB, deposits started to leave the bank, which meant that it announced a capital raise last week. This triggered a panic which led to a run on the bank. Now, the Canadian banks are much, much bigger than Silicon Valley and have a diversified customer base, which massively reduces their risk of forced capital raises. As well, they are highly regulated, and they are run much more conservatively. We think that the situation is a short-term aberration, and specific to U.S. regional banks. We expect a return to normalcy in the near term, and that the long-term prospects for the financial services companies remains strong.

How the various elements of the sector typically respond to a higher-rate environment.

JS: Financial services companies generally benefit from higher interest rates, but there’s some specific differences. So, let’s start with the banks. Generally, bank profitability increases as the spread widens out between what rate the bank borrows at, versus what it lends at. If the short end of the yield curve increases, then banks face a higher cost of funds. However, if the yield curve is upward sloping and the banks are lending slightly longer, then the spread widens out. So, in normal times, banks generally benefit from higher net interest margins or NIMs. But when the short end of the yield curve is above the middle of the long portion of the yield curve, NIMs may not necessarily widen that dramatically. So that’s the answer on banks. Now let’s turn to insurance companies. Insurance companies generally benefit from rising interest rates because their assets are portfolios of yield-producing securities against their claim liabilities. Thus, when yields go higher, insurance companies ultimately are benefiting from more investment income from the higher interest and coupons. Now, turning to money managers, those with lots of equities in their portfolios may not necessarily benefit from the higher rates because higher rates reduce P-E ratios, and that will impact assets under management. In general, when interest rates increase, investors in equities may demand a higher dividend yield, in order to hold stocks, rather than bonds whose yield is increasing.

How mortgage activity is impacting financial institutions.

JS: People with variable-rate mortgages are facing refinancing at significantly higher rates. This will impact financial institutions negatively. If rates go higher too quickly, then it may lead to loan defaults, increased credit loss estimates for the banks, which impacts profitability. The insurance companies do have exposure to mortgages but not to as great an extent and they are significantly more secure than the banks are.

How insurance companies look.

JS: I would say they are looking increasingly attractive. I mean, they’re a well-regulated industry in Canada, they are well financed, and they offer reasonably good growth, probably mid- to high-single-digit earnings per share growth, and they also offer attractive dividend yields of 3% to 5%. They can get you, you know, a 10% to 12% pretty well-defined rate of return. And so, they’re reasonably good investments. Since December 31 of 2021, Intact’s total return has been 24% and Manulife’s has been about 18%, both well ahead of the negative 1.5% of the TSX, and both well ahead of the banks with Royal [Bank] up 7%, being the top performer of the banks.

Where opportunities lie.

JS: The banks now appear a bit cheaper than the insurers on a P-E basis. Looking at the average bank P-E, it’s around 9.1 times, versus the insurers at 10.4 times. In terms of the cheapest multiples, it looks like Laurentian Bank is the cheapest bank, at around 6.9 times forward EPS, followed by Canadian Western Bank at 7.5 times consensus EPS, and Bank of Nova Scotia at 8.6 times consensus. Manulife is the cheapest life-co at around 8 times, and it’s also a high yielder at 4.9%. Intact Financial has excellent growth aspects from its core business, coupled with its proven merger and acquisition strategy. So, at current valuations, there are some very interesting opportunities in the industry.

And finally, what’s the bottom line on investing in the financial sector?

JS: There are always risks on the horizon. And the biggest risk is that interest-rate increases trigger loan and mortgage defaults. The banks are much more at risk in this scenario than the insurance companies are. So, we prefer the insurance companies’ exposure to the banks right now. My bottom-line message would be, proceed with caution when it comes to investing in the financial services sector.

Those are today’s Soundbites, brought you by Investment Executive and powered by Canada Life. Our thanks again to Joe Sirdevan of Galibier Capital Management.

Visit us at investmentexecutive.com, where you can sign up for our a.m. newsletter and never miss another Soundbite. Thanks for listening.

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