Enhancing Income from “Big Six” Canadian Banks

Key Takeaways

• “Selling volatility” helps investors harvest income from market uncertainty
• The strategy allows investors to manage macro and geopolitical risks
• Further upside and dividend growth still on the table for Canadian banks

1. Equity markets have recently faced enormous headwinds, from high inflation to the Russia-Ukraine conflict. How does a covered call strategy mitigate the impact of these risks?

CH: The benefit of a covered call strategy is its ability to add extra income to an investor’s portfolio, which increases portfolio yield generation and provides a buffer against potential losses. This is done by selling potential equity upside, in return for up-front income, which is a process that helps to generate enhanced income in all market environments. It’s important to note that the most significant driver of the premiums on covered calls is the level of volatility in the underlying equities. So, in more volatile markets like the ones we’re currently experiencing, income can be generated very efficiently.

When it comes to Canadian banks and the geopolitical risk emanating from the Russia-Ukraine crisis, investors can be comforted by knowing they have minimal direct exposure to both countries. The banks’ strength lies primarily in the areas of personal and commercial banking, capital markets and wealth management, which are largely focused in North America. All six companies have demonstrated strong performance over an extended period of time, providing additional peace of mind. While historical returns are not always a gauge for future returns, the performance of the Canadian banks, including during periods of market turmoil, adds confidence for many investors.

2. Rising rates have generally been positive for Canadian banks. Are those gains fully priced in at this point? Or is there more upside on the table?

CH: First off, it’s important to note there is still some uncertainty and differing opinions on the size and frequency of rate increases by the Bank of Canada this year. That said, the banks have already had a very strong run over the past 12 months. While some may think this sector is running out of steam given the outsize returns in 2021, bank stocks continue to trade at very reasonable valuations, with price-to-earnings (P/E) ratios well within their historical averages (see chart below). And it’s true that a rising rate environment will help to improve their net interest margins.

But this is really only one part of the story. In fact, the Canadian economy continues to show considerable resilience, with Q4 gross domestic product coming in slightly ahead of expectations at an annualized rate of 6.7%.¹

Moreover, many analysts are calling for Canadian equities to outperform U.S. equities this year. Additionally, as interest rates are forecasted to increase this year, the economy is expected to continue to perform well, helping the banks improve net interest margins.

3. In a previous article, you mentioned that regulatory changes could result in the “Big Six” raising their Q4 dividends by an estimated 18%. The increases eventually came in at 15.5%.² Does the gap suggest future dividend increases are imminent?

CH: Yes, we do see room for upward movement on dividends. Back in November when the banks made their initial announcements, some of them took a more cautious approach to dividend growth because this was their first opportunity to do so in quite some time. The caution was amplified for some banks due to some recent M&A activity that required capital expenditures; nevertheless, for the majority of the big banks, the climate is definitely constructive for dividends to grow for the remainder of 2022.

4. Will the strategy participate in upside growth if market fears subside and equity prices recover?

CH: The covered call strategy is deliberately designed to offer high levels of market participation for investors, even in strong upward markets. Recall that we only sell call options on half of the holdings in the portfolio, so the enhanced dividend overlay is undertaken on no more than 50% of the assets. Thus, when you get a strong market rally, the portfolio still accrues meaningful capital gains in addition to its options premia. It’s also worth noting that when market volatility increases, the options pricing range naturally adjusts to account for the uncertainty, creating more room for us gather income and manage market risks.

5. Chris, one last question. We like to end by asking for book recommendations that have shaped the way you think. What would you suggest for our Advisor audience?

CH: by Hans Rosling. The book highlights how cognitive biases can influence how people see the world—and how they can often see it incorrectly. Rosling presents a cognitive approach driven by understanding data on a deeper level, and by acting in a more prudent, rational manner. In terms of its connection to investment management, I believe it teaches us that a dispassionate, data-centric approach is usually more effective than one that’s emotional or visceral or based on preconceived ideas. On a more practical level, there are many lessons in the book that highlight better ways to understand and take action on a range of real-world issues.