After years of waiting, Bank of America Corp (BAC) stock investors finally got the news they had been hoping for in December: the Federal Reserve announced the highly anticipated first interest rate hike of the new tightening cycle! Everyone knows that higher interest rates pave the way for more profits and higher stock prices for banks…
Right?
As it turns out, since the rate hike was announced on December 16, the S&P 500 has lost 6%, while BAC stock has plunged 24%. What the heck is going on with the stock and where is the big interest rate bump that Bank of America stock owners were expecting?
Banks’ Core Business
To answer this question, we first have to look to why interest rates matter to BAC — and banks as a whole.
The core banking business is based on taking deposits and making loans. The key metric in assessing the profitability of this business is called net interest margin (NIM). NIM is calculated by subtracting the interest a bank pays on its deposits and debt from the interest it earns on its loans and securities. The result is then divided by the total value of the loans and securities to yield NIM.
Clearly, BAC stock owners want to see a high NIM. The higher the NIM, the more profitable a bank’s core business is, and the higher interest rates are, the more wiggle room banks typically have when it comes to NIM. A typical NIM for a bank in the 3% to 4% range, but the higher the better.
Here’s a look at the average NIM for all U.S. banks over the past decade, according to BankRegData.com.
As you can see, NIMs peaked at 3.84% in Q1 of 2010, but declined to new 10-year lows by Q1 of 2015. Q4 numbers showed some promise, however, with NIMs jumping back up to 3.35%.
Turning to BAC stock, the next graph comes directly from the company’s Q4 earnings presentation, indicating that NIMs (referred to as “net interest yield”) recovered only slightly in Q4 to a subpar 2.16% in Q4.
Bank of America clearly pronounced the benefits it expects to see from further rate hikes, stating that a “+100 bps parallel shift in interest rate yield curve is estimated to benefit [net interest income] by $4.3B over the next 12 months.”
Bank of America Stock: Bottom Line
In other words, BAC is sticking to its story that rising rates will lead to rising NIMs. It’s important to remember that the Fed’s rate hike happened at the tail end of Q4, but Q1’s earnings report could be the most important and telling report the company has produced in years.
Clearly, Bank of America has struggled to find its stride in the post-financial crisis world of low interest rates, strict capital requirements and government oversight. However, the stock’s recent 25% dive has once again pushed its price to tangible book value (P/TBV) below 1.0, down to 0.87.
Assuming an economic downturn doesn’t stop the Fed from further interest rate hikes, BAC stock seems to offer a rare combination of limited downside and a compelling earnings catalyst ahead in rising interest rates. Clearly, the 0.25% December rate hike did very little to immediately jump-start Bank of America’s share price. However, long-term investors realize that the gears of change turn very slowly sometimes, and Bank of America stock may now be set up favorably for years to come.
As of this writing, Wayne Duggan was long BAC.
