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Bond market's bad run puts squeeze on banks

The bond market is in the midst of its worst run since 1927. The face value of bonds, which moves in the opposite direction of yields, has dropped 8 percent in seven weeks.

That has created something of a tight spot for the nation's banks, whose business turns on interest rates.

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Banks usually benefit from rising long-term yields, because they're able to charge more for what they lend. But banks' holdings in the declining bond market could more than offset the traditional benefits of a steeper yield curve.

Some experts worry that if the bond market doesn't rebound, it will put a crimp in the second-half earnings of financial-services companies, which account for about 20 percent of the Standard & Poor's 500 index.

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A large percentage of the growth in second-half earnings is expected to come from financial-services stocks, including investment and commercial banks.

"Now that rates have gone up, it's going to be hard to deliver on those numbers," said Francois Trahan, chief investment strategist at Bear Stearns in New York.

Charles L. Hill, research director at Thomson First Call in Boston, disagrees about the impact.

"Is there danger of the numbers in the financials being cut back in the second half?" he said. "Sure, but I don't think we'll see a tremendous impact."

This divergence of opinion reflects the extraordinary interest rate environment. The Federal Reserve has pledged to keep its short-term interest rates at 45-year lows. But recent signs of economic recovery have made bond investors skeptical of that promise, and bond yields have soared.

Mortgage rates remain relatively low but have risen enough to cut weekly refinancing applications by 59 percent in the past few weeks.

On the one hand, the environment benefits banks as they engage in their traditional practice of playing the yield curve. The yield curve depicts the difference between short-term and long-term interest rates. Banks pay depositors interest based on the shortest rates but charge borrowers the longer rates.

"Deposits are very cheap, and banks are getting higher net interest on their loans," said Victoria Wagner, a director in the financial-services group at Standard & Poor's in New York. "This steepening should benefit net interest margins, which are the main driver of a bank's profitability."

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In early June, when the 10-year Treasury hit an intra-day low of 3.07 percent, bond veterans were marveling at how "flat" the yield curve was.

The longer a bond is held, the greater the risk rates might rise in the interim. With such an extraordinarily flat yield curve, investors were scarcely being compensated for the added risk of holding longer-maturity bonds.

Two months later, the shortest rates have hardly budged, but yields on the 30-year Treasury - where the yield curve ends - have risen nearly 30 percent. The abruptness of the move in longer-dated bonds has been so severe that it has resulted in the steepest yield curve in 50 years.

Dan Ellinor, regional president at Compass Bank in Dallas, said that on June 13, the day the 10-year Treasury hit its low, the savings rate that depositors were earning stood at 0.65 percent, and a 30-year fixed-rate mortgage with no points was 5 1/8 percent. Today, the rate paid to depositors has fallen to 0.55 percent, while the corresponding mortgage rate has risen to 6 3/8 percent.

As long as short-term rates hold at their historic lows, banks can apply the incremental dollars they are making on new loans straight to their profits.

The downside to rising rates is the falling value of the investments that banks have made to hedge against a falloff in commercial loan business.

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"Banks now hold more U.S. securities than they do commercial and industrial loans because businesses just don't want to borrow," said John Lonski, chief economist at Moody's Investor Service.

By his calculations, commercial and industrial loans, a bread-and-butter business for banks, have fallen by about 16 percent since their peak in February 2001. Banks have had to park their money somewhere, and many have chosen Treasuries.

By studying the Federal Reserve data published every Friday, Lonski figures that banks have increased their holdings of U.S. government debt by more than 40 percent in the past two years.

"To the degree that anyone holds longer-dated Treasury bonds, they've taken a beating," Lonski said. "The problem is that you hold Treasuries believing they are relatively safe investments. That's what makes these losses all the more stinging, because you don't expect to get hurt."

The bond market might recover, raising the value of banks' investments. Or the yield curve could get steeper.

Bear Stearns' Trahan said it's a misconception that banks' earnings are buoyed when the yield curve gets steeper. Moves in financial stocks are much more closely correlated to moves in the 10-year Treasury, he said.

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"You can explain 59 percent of the movements in financial stocks by moves in the bond market," Trahan said.

Trahan remains a minority voice on the subject. Most Wall Street analysts covering the banking sector have yet to adjust their earnings estimates.

"Certainly, we've seen a lot of people talking about the dangers of the bond market's fall," Thomson's Hill said. "But we're really not seeing the analysts react by cutting any of the estimates."

Not all banks are equally vulnerable.

"If banks are overloaded on low-coupon, fixed-rate debt, their profitability will probably not improve to the same degree as those banks that are better-positioned," said S&P;'s Wagner.

At Compass, Ellinor said the bank has sold $2 billion to $3 billion out of its bond portfolio since the beginning of the year. "We started selling in anticipation of rates going back up."


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