After months of anticipation, the Federal Reserve at its meeting earlier this month raised its benchmark overnight lending, the federal funds rate, by 25 basis points (0.25%). The market knew the move was coming, but what came as a surprise was the Fed's more hawkish outlook, indicating that it expects to make similarly sized rate hikes at each of its next six meetings in 2022. Then it's planning another four hikes in 2023 for a total of 11 hikes in two years.
Most banks, which tend to benefit from a little bit of inflation and rising interest rates so long as they don't push the economy into a recession, had been penciling in fewer hikes this year. While bank stock prices had definitely factored in the benefit from rate hikes to a certain extent, more rate hikes than projected this year also means there is the potential for banks to generate higher revenue and profits in 2022. Here are three bank stocks to buy.
1. Bank of America
One of the main moneymakers for most banks is net interest income (NII), the profit that banks make mostly on loans and securities after covering the cost of funding those assets. Rate hikes help NII because many yields on loans rise along with the federal funds rate. Bank of America (BAC 3.35%) is incredibly asset sensitive because of its large commercial loan base, which encompasses many floating-rate loans that adjust higher with the federal funds rate, and its multi-trillion dollar deposit base.
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In its 2021 annual filing, which came out in late February, Bank of America only expected the federal funds rate to be at 1% at the end of 2022. Seven rate hikes in total this year would put it around 1.75%. Management doesn't provide guidance on full-year expected NII, but if six more hikes materialize, expect NII -- and therefore total revenue -- to surpass initial projections, barring a recession that doesn't stunt projected loan growth. Chief Financial Officer Alastair Borthwick noted on the company's latest earnings call that the bank's balance sheet has grown considerably in recent years and that the bank is twice as sensitive to the federal funds rate than it was in 2015 when the last rate cycle began.
Furthermore, Bank of America has greatly improved its deposit base. Deposit costs go up along with the federal funds rate, so the banks that can bring in low-cost, sticky deposits can increase their margins the most. Longtime bank analyst Mike Mayo of Wells Fargo pointed out in a recent research note that roughly half of Bank of America's $2 trillion deposits are low-cost retail deposits from sources like checking accounts. He doesn't expect the rates on those to increase much through the first four or five rate hikes. Couple that with the fact that management expects to hold expenses flat this year and it's hard not to like Bank of America under the Fed's new plans.
2. Comerica
Based in Dallas with nearly $97 billion in assets, Comerica Incorporated (CMA 1.78%) is one of the most rate-sensitive banks in the industry. According to its annual filing, a 1% move higher in the federal funds rate would essentially grow NII by a whopping 12% over the next 12 months from the end of 2021 (although keep in mind these are just projections and rarely pan out exactly as expected).
More than 55% of Comerica's deposits are non-interest bearing, meaning the bank pays no interest on them. These are rate insensitive and are expected to be much more stable during a rising-rate environment. Furthermore, Comerica has high levels of cash right now, which it will earn a lot more yield on as rates go up by leaving them with the Fed or investing in securities, which will also see their yields rise along with the federal funds rate. With roughly 90% of total loans in various commercial segments, many of Comerica's loans also have floating rates that will reprice higher with the federal funds rate.
Considering management at Comerica had only expected four rate hikes this year, that leaves a lot of room for potential upside. The bank also has nearly a 2.9% dividend yield even with its stock up nearly 32% over the past six months, which is a nice value add.
3. Silvergate Capital
My last recommendation in this group is a much smaller, niche bank called Silvergate Capital (SI), which actually specializes in serving the crypto community. While it doesn't hold Bitcoin or other cryptocurrencies on its balance sheet, the bank has created a real-time payments system that enables any party on the network to send and clear funds instantly at any time.
The payments network solves an important problem for institutional traders looking to trade with cryptocurrency exchanges, because while cryptocurrencies trade constantly, most of the U.S. financial system doesn't operate in real time. Parties that use Silvergate's payments system must set up bank accounts with Silvergate that usually include large amounts of non-interest-bearing deposits. In fact, Silvergate essentially gets its entire deposit base for free.
Even better for investors worried about a recession is that the bank isn't really too dependent on loans. Only roughly 12.5% of its deposits are funding loans. Roughly 54% of its total assets, or roughly $8.6 billion, are invested in fixed income securities. The bank's overall securities book in the fourth quarter of 2021 had a yield of 1.04%. Silvergate has another roughly $5.4 billion sitting in cash. With the yield on the U.S. 10-year Treasury recently at 2.16%, the bank will make a lot more money on excess cash and new securities deployment.
Silvergate will likely have to hold more cash than normal banks due to the nature of its business. The stock also does to some extent move with the price of Bitcoin and deposit flows may be influenced by crypto trading levels. But in its annual report, Silvergate estimated that a 1% move higher in the federal funds rate would generate an additional nearly 60% of NII over the next year. That's simply astonishing, but keep in mind that it's still just a projection -- and investors will all be waiting to see if, in fact, the Fed raises rates six more times this year.
