The Federal Reserve recently commenced what could be the first of many increases to its benchmark overnight lending rate this year, and many banks are poised to benefit. But few will benefit like Bank of America (BAC 1.53%), which has significant exposure to higher rates.
Higher interest rates will increase the yield attached to many of Bank of America's existing and future loans, as well as the debt securities in which the bank deploys cash. Here are two charts that show why Bank of America is a good stock to have in this kind of rising-rate environment.
1. Margin expansion
Source: S&P Global Market Intelligence (formerly S&P Capital IQ).
One way to look at the profitability of a bank is through its net interest margin (NIM), which essentially is the difference between the average yield on a bank's assets, such as loans and securities, and the average yield on its funding sources, such as deposits. As you can see above, during years when rates have steadily been on the rise, such as between 2015 and the middle of 2018, Bank of America's NIM has steadily risen.
Even better in the current rate environment, Bank of America has greatly grown its low-cost retail deposits, which tend not to be very sensitive to rising rates and, therefore, won't be pulled out of the bank by depositors at the first sign of higher yields elsewhere. That allows Bank of America to keep its funding costs more stable and rise less so than the yields on its assets.
Image source: Getty Images.
Bank of America's CFO Alastair Borthwick pointed out on its most recent earnings call that the bank is now twice as sensitive to short-term interest rates (like the federal funds rate) than it was when rates began rising last time in 2015. That can already be seen in Bank of America's net interest income (NII), the profit it makes on loans and securities after covering the cost of funding those assets, which at $11.5 billion in the fourth quarter of 2021 is not much lower than NII at the end of 2017 when the federal funds rate had already topped 1.25%.
Bank of America also has way more of its cash deployed into debt securities than it has in the past. That portfolio will see its overall yield rise as the Fed continues to raise interest rates.
2. Return on equity
BAC Return on Equity data by YCharts.
Another way for investors to see how Bank of America has performed in a rising-rate environment is by looking at its return on equity, which measures the bank's profits as a percentage of its total equity. This includes preferred equity, shareholder capital, retained earnings, and more.
As you can see in the chart above, return on equity has more or less increased in tandem with the federal funds rate. When the Fed dropped the federal funds rate to zero during the pandemic in 2020, return on equity declined sharply and then picked back up in 2021. That pick-up was largely due to some non-recurring and lumpy items such as the bank provisioning for heavy loan losses at the beginning of the pandemic when there was incredible uncertainty. Because those elevated loan losses never materialized, it was able to release that capital back into earnings in 2021. Loans from the Paycheck Protection Program also helped.
A calculated bet
There are risks for banks. For instance, rising rates can increase deposit costs, slow consumer demand, and lead to more defaults on loans. Many analysts and experts are also predicting the U.S. will enter a period of stagflation, which could dampen loan growth, a key factor that impacts how banks benefit from rising rates. But considering Bank of America's strong deposit base, significant levels of cash and cash deployed into securities, and sensitivity to shorter-term interest rates, I'm bullish on Bank of America and believe the stock is a good pick in this kind of rising-rate environment.
