The potential effect of rising interest rates on the economy and stock market has been one of the major themes circulating through the financial media over the past several months. Indeed, the yield on the 10-year U.S. Treasury bond is on the upswing, having recently reached 3%. This has caused a great deal of fear of rising costs for companies reliant on debt financing within their capital structure.
Of course, if rising interest rates are a bad thing for borrowers, then conceptually, the opposite must be true. That's why investors looking for stocks that will benefit from rising interest rates should consider the major banks, including Wells Fargo (NYSE:WFC) and JPMorgan Chase (NYSE:JPM).
How rising rates work in banks' favor
First, rising interest rates are frequently symptomatic of an improving economy. That means that as the economy gets healthier, it's only natural for interest rates to slowly move off of their historically low levels. A healthier economy will result in consumers more easily paying off their loans, resulting in lower loan-loss reserves and improved profitability for the nation's banks.
This is reflected in the banks' earnings reports for the fourth quarter and full year. Wells Fargo's positive momentum has accelerated throughout the year. It registered record net income in both the fourth quarter and in 2013. Full-year net income grew 16%. Its return on equity expanded by 92 basis points during the year.
Moreover, Wells Fargo's credit quality improved dramatically throughout the year. Net charge-offs totaled just $963 million, representing a $1.1 billion decrease year over year. And its non-performing assets fell by a whopping $4.9 billion. Wells Fargo's clear improvement in credit quality signifies the progress made in the U.S. economy.
It's abundantly clear that the big banks are back to generating massive profits. JPMorgan is seeing a similar pattern, evidenced by the company's fourth-quarter and full-year results. JPMorgan generated $5.3 billion in profit in the fourth quarter and $17.9 billion in profit for all of 2013. Specifically, the bank's provision for credit losses shrank to just $72 million in the fourth quarter, compared to $1.1 billion in the same quarter the year prior.
It's important to note JPMorgan's profits were negatively affected by $1.1 billion in legal expenses pertaining to the Bernie Madoff settlement. However, management was quick to note that it was prudent to resolve these issues and move on, and now JPMorgan can focus on its core business of serving its clients.
Reduced net charge-offs represent a major tailwind for Bank of America (NYSE:BAC), perhaps more so than its rivals. Bank of America got hit the hardest of the three major U.S. banks during the heart of the recession, and as a result, it's seeing the biggest gains on the way back to health. Bank of America's most recent results handily beat estimates.
For example, its fourth-quarter charge-offs dropped a whopping 49% in the fourth quarter, year over year. Moreover, Bank of America's Basel Tier 1 ratio stood at approximately 11.1% after the fourth quarter, which is higher than both Wells Fargo's and JPMorgan's Tier 1 ratios.
A secondary benefit for banks
Since bank profitability is reliant on the spread between what they earn by investing deposits and the costs of paying interest on those deposits, rising interest rates are benefiting banks in a separate way. Even though long-term interest rates are going up, interest rates on savings accounts and certificates of deposit have moved very little during this period. This means bank spreads are widening even further, which will result in enhanced profitability going forward.
It's clear that rising interest rates are working in the banks' favor in several ways. Wells Fargo, JPMorgan, and Bank of America are seeing improved core metrics, including lower loan loss reserves, reduced charge-offs, and improved credit ratios. In addition, since interest rates payable on savings accounts and CDs have remained at extremely low levels, bank profits should swell even further.