This year, multi-decade-high interest rates helped create a challenging operational environment for many bank stocks. The abrupt failures of Silicon Valley Bank (a subsidiary of SVB Financial), Signature Bank, and First Republic Bank earlier this year brought intense scrutiny to the entire sector.
Concerns about the sector spooked many investors and led to the SPDR S&P Regional Banking ETF falling 27% since the start of 2023. KeyCorp (KEY 0.62%), the parent company of KeyBank, underperformed its peers and its stock is down 34% year to date. KeyCorp's margins are under pressure, and a recent downgrade only added to its problems.
And yet, KeyCorp now presents an intriguing long-term investment opportunity if it can navigate these near-term challenges. If you're thinking about buying the stock, here are some issues to consider.
KeyCorp's recent credit downgrade highlights the bank's struggles
KeyCorp made news last month when S&P Global downgraded its credit rating from BBB+ to BBB. The rating agency stated that higher-for-longer interest rates "will constrain profitability at Key more than at large regional bank peers."
Banks make money on the net interest margin, or the difference between the interest earned on loans and the interest paid out on deposits. Rising interest rates tend to be a good thing for bank stocks. That's because banks can earn higher interest on their loans, which can help widen their net interest margin. We saw the positive effects of rising interest rates last year as banks grew net interest income at the fastest pace in years.
However, interest rates have risen very quickly, putting pressure on bank deposits. Because bank deposits haven't paid out attractive yields, depositors have looked elsewhere to generate income. As a result, customers are moving cash into high-yield savings accounts or other high-yielding investments, like certificates of deposit, where they can earn up to 5.5% interest.
Margins have compressed and net interest income is falling
To keep pace with these rising rates, banks must offer more appealing returns for customers to keep their deposits. When the Federal Reserve began raising interest rates, KeyCorp's cost of deposits was a measly 0.06%. At the end of the second quarter, this figure has risen to 1.49%. As a result, its net interest margin shrank from 2.74% in the third quarter last year to 2.12% in Q2 of this year. Net interest income fell from $1.2 billion to $986 million in the same period.
Data source: KeyCorp. Chart by author.
Earlier this year, KeyCorp management projected that its net interest income would decline between 1% to 3%. That figure has been revised significantly to a 12% to 14% decline. Its slashed guidance has many investors concerned about its dividend, which has risen for 11 consecutive years and currently yields 7.21%.
How KeyCorp plans to bounce back
It's not all doom and gloom for KeyCorp. The bank is well-positioned to improve its margins and balance sheet. Over the next year, some of its lower-yielding assets will mature, and it can reinvest them at higher interest. Management projects that this shift from low-yielding to high-yielding assets could benefit its net interest income by over $900 million on an annualized basis by 2025.
Another factor KeyCorp has going for it is its credit quality. The bank has reduced its exposure to office property loans, one area of commercial real estate deemed higher risk by industry experts, to less than 1% of its total loans. Additionally, its net charge-offs of 0.17% in the second quarter are well below the industry average of 0.46%.
Is KeyCorp stock a buy?
Potential investors in KeyCorp stock have several factors to consider. The bank faces falling net interest income and compressing margins in the short term, which could lead to continuing volatility in its stock price. The stock price seemingly reflects these concerns, with the bank valued at 1.25 times tangible book value, creating an intriguing price point for value investors.
KEY Price to Tangible Book Value data by YCharts
If the bank successfully navigates these near-term challenges, it can take advantage of higher interest rates as some of its lower-yielding assets mature in the next year. It looks well-positioned with its high credit quality, which should help it weather near-term challenges that all banks face today. Considering all the factors above, KeyCorp stock looks like an attractive buy at today's prices.
