The bond market rout will cause short-term difficulties for banks

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Higher interest rates should benefit the banking sector this year, but could be a shorter-term pain for banks whose bond investments have recently come under fire.

Banks’ sagging bond portfolios are a downside of higher interest rates, which are generally helpful to the industry, since lenders typically raise the rates on their loans faster than they raise the yields they pay on deposits.

Analysts still expect the benefits of higher rates to easily outweigh the unrealized losses they see on their bond portfolios, which have fallen in value as inflation hits levels not seen in decades, and the Federal Reserve begins to put the brakes on the economy.

But the reversals some banks are expected to report in the first quarter are just “another negative narrative” that has been piling up on bank stocks, said Chris McGratty, an analyst at Keefe, Bruyette & Woods. He remains bullish on the sector but says it appears to be less of a “slam dunk”, also highlighting concerns over inflation, a possible recession and geopolitical uncertainty.

“There are going to be some good hits,” McGratty said. “Rates have been moving at a really, really fast pace.”

The yield on the 10-year Treasury bond jumped to 2.66% on Thursday, up sharply from 2% on March 11. Banks looking to deploy excess cash into bonds could benefit from investing in higher-yielding options, but they’re dealing a blow to their existing bond portfolios, whose prices have fallen now that higher-yielding options are on the way. available.

The sharp rise in Treasury yields “is unlikely to benefit banks” until the end of this quarter and beyond, Wells Fargo Securities analyst Mike Mayo wrote in a research note. Instead, the rate moves will likely mean some banks’ book values ​​could be flat or possibly down, and big banks could rethink the pace of their stock buybacks.

The headaches are for securities that banks have marked as “available for sale,” as companies will need to update the value of those securities for their financial statements.

U.S. banks reported net unrealized losses on their available-for-sale securities year-to-date, with $80.8 billion in unrealized losses in the week ending March 23, the data shows. from the Fed. The losses mark a sharp reversal from 2020 and 2021, when the industry consistently reported unrealized gains amid low interest rates.

The extent of each bank’s hit will depend in part on whether it takes steps to protect against rising rates, either by hedging or by removing the “available-for-sale” label from securities in advance.

For the vast majority of banks, the impact would only manifest itself by reducing their tangible book value. But the regulation of big banks forces them to consider the impact on their regulatory capital, which may make them a little less willing to distribute excess capital to shareholders by buying back shares.

“This, combined with the uncertainty resulting from the Russian-Ukrainian conflict, should lead banks to take a cautious approach to buybacks,” Morgan Stanley analyst Betsy Graseck wrote in a recent note to clients.

She flagged the three largest trust banks in the country – Bank of New York Mellon, State Street and Northern Trust – as one group likely to see more capital hit.

BNY Mellon’s chief financial officer, Emily Portney, told a Credit Suisse conference in February that the bank was “cautious about redemptions” in the first quarter, but still intended to return all of its profits to shareholders over time.

She said the “significant movement in rates” has put pressure on accumulated other comprehensive income, the line item where banks list unrealized gains or losses on their available-for-sale securities. She also noted that BNY Mellon had taken “proactive steps” to reduce the volatility of its capital requirements.

JPMorgan Chase chief financial officer Jeremy Barnum said at the same conference that accumulated other comprehensive income was “consuming capital” due to the higher rate environment.

Analysts also identified Truist Financial, US Bancorp, KeyCorp, Zions Bancorp., Cadence Bancorp. and Comerica as banks that have larger quantities of securities available for sale and could see their book value more affected.

Some banks have changed their bond portfolios over the past year to limit volatility. To do this, they moved securities that were previously marked as “available for sale” to “held to maturity” because the latter designation does not require the same update of security values.

Truist and US Bancorp recently moved some of their available-for-sale securities to held-to-maturity securities, and analysts expect other banks to disclose that they have taken similar action or may do so. To do. While that would “not immunize these banks” against a blow this quarter, it would reduce volatility for quarters to come, McGratty wrote in a note to clients.

Higher rates also increase the possibility that banks will spend more of their idle cash on securities and lock in higher interest rates. Earlier this year, the chief financial officers of JPMorgan and Wells Fargo both said they wanted to remain patient in deploying cash into securities because interest rates had significant room to rise.

That math could start to change a bit, though banks might also want to conserve cash and use it to fund an expected rebound in lending.

“Banks would much rather make a loan than buy a bond, but it’s really a balancing act,” McGratty said.

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