Many banks will benefit from the Federal Reserve’s recent increase in its benchmark overnight lending rate. However, not all banks will be able to benefit. Bank of America( BAC -2.00% )This is a significant exposure to higher rates.
Higher interest rates will increase both the yield attached to many Bank of America’s future and existing loans as well the yield of the debt securities in the bank’s cash deployments. These two charts show why Bank of America stock is a good choice in this rising-rate environment.
1. Margin expansion
The net interest margin (NIM) is a way to measure the bank’s profitability. It is simply the difference between the average yield of assets such as securities and loans, and the average yield from its funding sources such as deposits. As you can see, Bank of America’s NIM has steadily increased over years when rates have been steadily rising, such as 2015 to the middle of 2018.
Even better, Bank of America has significantly increased its low-cost retail deposits. These deposits are not very sensitive to rising rates, and will not be withdrawn by depositors at any time there is a rise in yields. This allows Bank of America’s funding costs to remain stable and to rise less than its assets’ yields.
Source: Getty Images
Alastair Borthwick, Bank of America’s Chief Financial Officer, stated on its latest earnings call that the bank is now twice the sensitive to short-term rates (like the federal fund rate) than it was in 2015 when rates started rising. This can be seen in Bank of America’s net interest income (NII), which is the bank’s profit on loans and securities after covering the costs of funding those assets. It was $11.5 billion at the fourth quarter of 2021. This is not much lower than the NII at 2017’s end when the federal funds rates had already topped 1.25 percent.
Bank of America also has more of its cash invested in debt securities now than it did in the previous. As the Fed increases interest rates, that portfolio will see its overall yield rise.
2. Return on equity
BAC Return on EquityData courtesy YCharts.
An alternative way for investors to assess how Bank of America has performed under rising rates is to look at its return on equity. This measures the bank’s profits as a proportion of its total equity. This includes retained earnings, shareholder capital, preferred equity, and shareholder capital.
As you can see, the federal funds rate has increased more or less in tandem with return on equity. The Fed reduced the federal funds rate from zero to zero in 2020 during the pandemic. However, the return on equity dropped sharply before picking up again in 2021. This was due to some non-recurring, lumpy items like the provisioning by banks for large loan losses during the pandemic’s beginning. Because the high loan losses did not materialize, the bank was able release that capital back into earnings for 2021. Also, loans from the Paycheck Protection Program were helpful.
A calculated bet
Banks face risk. Rising rates can lead to increased deposit costs, slower consumer demand, and more defaults on loans. Experts and analysts predict that the U.S. will experience stagflation. This could impact how banks can benefit from rising rates by reducing loan growth. But, Bank of America’s strong deposit position, substantial cash and cash invested in securities, and sensitivity towards shorter-term interest rate fluctuations make me bullish on the stock. I believe it is a great pick for this type of rising-rate environment.
This article is the author’s opinion. He or she may disagree with the official recommendation of a Motley Fool premium advisory services. Were we motley! Were motley!
