Lower bond yields may finally give bank stocks the break they need.
After bank stocks surged Tuesday as better-than-expected inflation data pushed yields lower, some on Wall Street are getting optimistic that a more durable recovery is in the works.
Higher bond yields help banks initially, allowing lenders to earn more interest on assets. But when interest rates rise too fast—as they have during the Federal Reserve’s recent tightening cycle—bank stocks suffer.
All at once, banks’ funding costs have crept up, while the value of the bonds on their balance sheets has fallen. Lending is under pressure because higher rates makes banks hesitate to extend new credit as they fret over potential delinquencies on existing loans.
But if the drop in bond yields persists, bank stocks should see a reversal of all that, providing ample room for prices to rise. It is surely needed: Even with recent gains, the
SPDR S&P Bank ETF
(ticker: KBE) is down about 12% so far this year while the
has climbed 17%.
Bond prices fall when yields rise, so the Fed’s rate increases have left banks with hundreds of billions of dollars of unrealized losses on their bond portfolios. Lower bond yields could “accelerate a fair value rebound,” helping to unwind those losses, Jeff Rulis, senior research analyst at D.A. Davidson, wrote Wednesday.
The timing would be excellent because reversing those losses would reduce one headache banks have faced. Not only would the losses themselve be smaller, but the banks would need to hold less capital against those bondholdings.
Banks are required to hold more capital against assets that are considered riskier—such as certain bonds and loans—which harms their profitability.
Banks have also had to worry about consumers having difficulty paying back their debts. Delinquency rates are still historically low but are creeping towards prepandemic levels, creating a greater need for capital under regulatory requirements.
A reversal of those unrealized losses in bond portfolios “could serve as a cushion for potentially elevated credit costs,” Rulis wrote. He sees banks with Tier 1 capital ratios of less than 7%, such as Comerica (CMA),
(ZION), and Fifth Third Bank (FITB), among others, as benefiting.
A drop in bond yields can boost banks in other ways, too. The interest rates borrowers pay are tethered to the rates on Treasuries. Higher interest rates have made people more hesitant to seek new mortgages while also making businesses more reluctant to take on debt for new projects. As yields tick down, some of those would-be borrowers could come off the sidelines.
The notion that low rates could boost banks isn’t without precedent. Bank stocks climbed 54% on average in 1995, after the Fed cut interest rates twice, demonstrating to investors that the period of monetary tightening between January 1994 and February 1995 was over, Gerard Cassidy, analyst at RBC Capital Markets, wrote Wednesday.
With bank stocks still trading at a slight discount to historic valuations, Cassidy is getting bullish on the sector.
“We continue to believe that if the Fed reaches the terminal rate in the near future, bank stock prices will rise and at these low valuations, investors will be rewarded,” Cassidy wrote.
It’s just the type of news bank investors have needed.
Write to Carleton English at [email protected]