While banks tend to perform well in a rising-rate environment, some odd movements in the bond market have hurt bank stocks this year and sent shares of many down from the record highs they reached in late 2021 and at the very beginning of 2022.
The yield curve, which displays the interest rates of U.S. Treasury bills of varying maturities, has gone from a steeply rising slope to a much flatter shape. Some parts of the yield curve have even inverted, meaning shorter-term yields are high than longer maturities. This has made some investors wary of the banking sector.
Banks benefit from a steep curve, in which longer-term T-bills pay out more interest than shorter-term T-bills. That's because banks are known for borrowing money in the short term and lending it out over the long term, so when the curve steepens, their margins expand. But when the curve flattens or inverts, shorter-term U.S. T-bills start paying similar or more yield than longer-term T-bills, which can then hurt bank margins.
Despite that recent shifts in the yield curve, I am not worried about a stock like Bank of America ( BAC -0.78% ) right now, which is one of the biggest beneficiaries of a rising-rate environment in the industry. Here are three reasons I still think Bank of America can perform well in this kind of yield-curve environment.
Image source: Getty Images.
1. Only parts of the yield curve have inverted
Yes, parts of the yield curve have briefly inverted, such as the difference in the yields between the two-year and 10-year T-bills, as well as the difference between the five-year and 30-year T-bills. But for bank stocks, the part of the yield curve that is actually most important is the difference between the three-month and 10-year T-bills. That's because this gap is much more indicative of bank margins, and funding costs don't really track the two-year yield.
Three-month Treasury rate. Data by YCharts.
There are still about 180 basis points (1.8%) between the three-month Treasury rate and the 10-year Treasury. Banks have greatly improved their deposit bases, which are now more sticky and less sensitive to changes in the Federal Reserve's benchmark overnight lending rate.
I also put the five-year T-bill yield on the chart because that rate influences a lot of interest rates on commercial and business loans, and Bank of America is one of the largest commercial lenders in the country. The five-year has overtaken the 10-year, so bank margins at this part of the curve are even wider. Additionally, mortgage rates, which are heavily influenced by the 10-year T-bill rate, are the highest they've been since 2018, so banks are probably able to make a nice spread on mortgages right now, even if higher interest rates can slow homebuying.
2. Bank of America is awash in deposits
BAC total deposits (quarterly). Data by YCharts.
Since the start of 2020, Bank of America has increased deposits by about $600 billion. It now has more than $2 trillion in deposits, but only had about $945 billion of total loans at the end of 2021, leaving Bank of America awash in excess deposits.
More than $1 trillion of the bank's deposits are from its consumer bank, which tend to be more stable and less sensitive to rising interest rates. Wells Fargo analyst Mike Mayo noted in a recent research note that he doesn't think Bank of America will need to worry about costs on this $1 trillion of consumer deposits for the first four or five rate hikes in this cycle.
3. The short end of the curve is where it's at
Many people think that interest rates at the short- and long-end of the curve need to move in a parallel fashion to preserve bank margins, but in recent years, Bank of America has become much more sensitive to shorter-term rates. Its chief financial officer, Alastair Borthwick, noted on the previous earnings call that the bank is now twice as sensitive to the short end of the yield curve as it was back when the last rate-hiking cycle began in 2015.
Borthwick added that 75% of its projections for higher net interest income (NII) -- which is the profit banks make on loans, securities, and cash after paying to fund those assets -- is tied to the short end of the curve.
Additionally, with all of its excess deposits, many of which were earning practically nothing at the end of 2021, Bank of America could -- if it wanted to -- invest in two-year T-bills (which are currently yielding 2.34%) and significantly increase its profits. That's advantageous as well because locking into a two-year bond is a lot less of a commitment than locking into a 10-year bond.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis – even one of our own – helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.
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3 Reasons Bank of America Can Still Perform Well in a Difficult Bond Market - The Motley Fool
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