Bank of America (BAC -0.21%) kicked off the latest earnings season last week by beating analysts' earnings estimates. The second-largest bank in the U.S. showed its resilience despite higher interest rates that have begun to drag on net interest income.
Its relatively cheap valuation and the prospect of a Federal Reserve pivot on interest rates could make Bank of America an appealing stock to scoop up. Here's what you should know first.
Bank of America is very sensitive to changes in interest rates
Bank of America, also known as BoA, is the second-largest bank in the U.S., and its diverse deposit base -- spread among industries, geographies, and customer classes -- provides a steady anchor to navigate whatever the economy throws at it. This diversity is important for the bank because its business is highly cyclical, meaning it generally performs well during economic expansion but can underperform during contractions and recessions.
Banks also benefit from rising interest rates (to an extent), and BoA is one of the most interest-rate-sensitive banks out there. Banks tend to benefit early on from interest rate increases because they can earn higher interest on their assets, while deposits take longer to adjust to interest rate changes. In 2022, BoA's net interest income (NII) grew 22% as the Federal Reserve aggressively raised interest rates to stomp out inflationary pressures. Last year, BoA's NII rose another 8.5% to $57 billion.
Conversely, higher interest rates can be a double-edged sword for banks. For example, BoA's NII dipped 5% in the fourth quarter as its deposit costs rose industrywide. BoA's interest-bearing deposit costs were 2.5% in the fourth quarter, up from 2.2% in the third quarter and just under 1% the year before. As a result, its yield on earning assets declined from 2.1% to just under 2% in the quarter.
Higher interest rates continue to weigh on BoA's loan portfolio
One often-scrutinized number for BoA is the unrealized losses on its loan portfolio. When interest rates rise, loans, bonds, or other securities a bank holds are less attractive compared to those that could be made at higher rates, which is why bond prices and interest rates are inversely related.
In the fourth quarter, BoA had $102 million in unrealized losses on its debt securities. These unrealized losses could impact capital ratios or make banks more cautious about loans. On a positive note, this amount is down from $136 million in unrealized losses in the third quarter, as interest rates declined across assets in the fourth quarter, raising the value of its holdings.
These unrealized losses aren't a problem as long as the bank can hold them for the long term. One problem with the regional banks that failed last year was the huge deposit outflows, which reduced their funding base. Some niche banks, like Silicon Valley Bank (a subsidiary of SVB Financial) or Silvergate Bank, relied on low-cost deposits to fund their business. However, they were the first to see deposits flow out for various reasons and were forced to raise capital or sell their loans at significant losses.
Fortunately for BoA, the bank continues to grow its deposit base. At the end of the quarter, its total deposits of $1.9 trillion are up slightly, increasing 0.7% since the Fed began raising interest rates in Q1 2022. While this growth is modest, it's a positive sign and testament to its diversified deposit base that helps it endure difficult times.
Image source: Getty Images.
Keep an eye on consumer credit metrics
Another key metric investors will want to watch is BoA's credit quality. Consumers are racking up debt, surpassing $1 trillion in credit card debt last year. Higher rates have put pressure on consumers who have relied heavily on credit card loans, one area where BoA saw a sizable uptick in charge-offs. In the fourth quarter, its net charge-off rate on consumer credit card loans was over 3%, up from 2.7% in Q3 and 1.7% one year ago. However, charge-offs across its entire loan portfolio were 0.45%, which is still in line with pre-pandemic levels.
Because of the cyclical nature of bank stocks, investors will want to keep an eye on the bank's credit quality. Rising charge-offs could lead to even more reserve builds, which could weigh on the bank's bottom line in the near term.
BoA's cheap valuation makes it an appealing value stock
The turbulence in the banking industry over the past year has BoA trading relatively cheap compared to recent history. While the stock has run up 28% from its low point in October, its valuation is still reasonable, with the stock trading at a 5% discount to book value and 1.3 times tangible book value (which strips out any intangibles, like goodwill). It's also well below its 10-year average price-to-earnings ratio.
BAC Price to Book Value data by YCharts. PE Ratio = price-to-earnings ratio.
Is Bank of America a buy?
Bank of America is relatively cheap and is well-positioned to benefit from possible interest rate cuts by the Federal Reserve in 2024. According to CME Group's FedWatch Tool, markets are currently pricing in seven interest-rate cuts, bringing the federal funds rate from 5.5% to 3.75% through the end of this year.
As noted above, higher interest rates weigh on BofA's net interest margin and loan book, so lower rates should alleviate those pressures. This reduction in interest rates could also spur loan demand among consumers and businesses that have been waiting for lower interest rates to refinance or take out new loans.
Bank of America is a solid bank stock worth holding, and today could be a good time to buy a few shares. Even so, with the recent 28% run-up over the past several months, it wouldn't be too surprising if the bank stock were to dip by 10% to 15% over the short term. That could be a great chance to add more shares, as a Fed pivot will likely benefit it more later in the year and beyond.
