For investors seeking dividends, it’s finally safe to return to the U.S. financial sector

With payout freezes lifting, now is the time for dividend seekers to return to U.S. banks

American flag in front of Citi Group logo

Tired of relying on Canadian REITs and utilities for income? Try U.S. banks. (Brendan McDermid/Reuters)

The financial sector is a natural place to look for yield in the Canadian equity market. Not so south of the border. It has to do with recent history: Between Sept. 15, 2008, the day investment bank Lehman Bros. filed for Chapter 11, and March 6, 2009, when the market bottomed out, the S&P 500 financial sub-index fell by a stunning 68%. Shareholders didn’t just rack up the capital losses, though. Over the same period, the average U.S. bank dividend was slashed by 72%.

The sector has since recovered—stock prices are up 283% from that 2009 nadir—yet dividends remain depressed. Between 2004 and 2007, U.S. financials accounted for about 30% of all the dividends paid on the S&P 500. That fell to 9% in 2009 and has climbed back to nearly 15% today. While some banks, such as Wells Fargo, are paying more per share than they were before the recession, others, like Citigroup, haven’t increased dividends at all.

Some investors may still feel burned by the dividend cuts, but now is not the time to hold a grudge. Yields are going to rise, says James Morrow, manager of Fidelity Investments’ U.S. Dividend Fund, and income-­seeking investors should buy in be­fore the masses rush into these stocks. “It’s still early innings,” he says, “but banks will slowly get more aggressive.”

Financial company dividends are still low because they have to be. Banks didn’t choose to cut their payouts in 2008; it was regulators that forced them to divert cash flow to raise their capital reserves. They are still being cautious. Each bank has to pass a rigorous stress test before it can resume returning capital to shareholders. Citigroup, which usually has one of the best Tier 1 capital ratios (a measure of financial durability), failed its most recent stress test in June. It can’t raise its dividend or buy back shares until it passes.

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Most banks, even those that haven’t raised dividends, are in much better shape than they were before the recession, says Morrow. They have “dramatically” more cash on their balance sheets, he says, and they’ve taken on less lending risk than they did in the past. As time goes on, all of the big banks should pass these tests, and when they do, their dividends will rise. “Do the banks have more capacity today to raise capital, shore up balance sheets and potentially return that capital to shareholders? Yes, they do,” says Gareth Watson, vice-president of investment management and research at Richardson GMP.

It’s still unclear just how much payouts will grow. Those companies that have been allowed to increase their dividends thus far have done so substantially. Wells Fargo, for instance, boosted its annual dividend by 565%, from 20¢ in 2010 to $1.33 today. JPMorgan’s payout has climbed by 670% since 2010.

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While financial stocks with paltry payouts have the greatest yield growth potential, Morrow thinks every U.S. bank will continue upping its dividend. Before the recession, the average payout ratio (the share of free cash flow allocated to dividends) was around 50%. It’s now closer to 30%.

For Canadians tired of buying expensive REITs and utilities, U.S. financials present a good opportunity for both capital appreciation and dividend growth. “It’s going to happen,” says Morrow. “Banks are producing excess capital, and they’re going to need somewhere to put it.”