Why bank bonds are sitting ducks in the next downturn

Two years ago I developed a thesis about the negative effect of the Federal Reserve’s interest rate policies on bank balance sheets based on my understanding about the history of zero rates in Japan. For bank bond investors, this should be worrisome.

In November 2010, I wrote a post noting that the long end of the yield curve would come in due to the Fed’s zero rates, flattening the yield curve and compressing interest margins. This is what we witnessed in Japan in the aftermath of their housing bubble and the result was zombie banks made especially vulnerable during downturns. See my August 2011 post on toxic zero rates that spells all of this out in greater detail.

The point, of course, is that while the Fed is desperately trying to engineer a recovery by reducing debt burdens for a highly indebted household sector, its policy has the unintended consequence of reducing interest income at financial institutions, which are still overburdened by weak balance sheets.

Last night, I ran across an interview with Sallie Krawcheck, a former Citigroup CFO, who makes the same case.

Krawcheck said that the Federal Reserve’s zero-interest rate policy is hurting bank earnings more than most on Wall Street expected. Net interest income is far more important than many analysts and executives realized.

“The other thing that is happening — which I think almost everybody underestimated — what’s happened with interest rates as they’ve gone close to zero as the yield curve has been relatively flat as there’s been no loan demand, the net interest income has declined dramatically,” she said. “I think one thing analysts and commentators — and in fact some bank execs perhaps — didn’t fully recognize is that net interest income is a very powerful driver of the bottom line.”

Krawcheck said the most important thing for investors looking at the current market environment to do was to understand their risk profile — which she said few investors do accurately — and allocate assets appropriately.

Just last month, Krawcheck repeated this warning in an article in the Harvard Business Review, but also implying that lower net interest income was a secular change which bank investors should be anticipating. I have bolded the part where she makes this suggestion:

Net interest income is a fundamental part of banking. Banks collect deposits in return for paying a certain rate of interest, and they use the deposits to make loans at a higher rate. The spread between those two rates — the net interest margin — fluctuates for a number of reasons, most of which are out of banks’ control. A key factor is the external interest-rate environment. A steep yield curve, on which long-term rates are much higher than short-term ones — as can happen when the Federal Reserve drives down short-term rates with an easy money policy — tends to increase net interest income, whereas a flat one does the opposite.

Suppose a steepening yield curve drives a bank’s net interest margin from 250 basis points (2.5 cents on the dollar) to 350. That added penny on the dollar falls directly to the bottom line. The bank doesn’t have to do any more work, open any more branches, or answer customer calls any more quickly. And when the yield curve flattens, revenue goes down without any associated decrease in costs. So changes in net interest income can have a powerful effect on a bank’s earnings while giving no indication of how well the bank is serving its customers or how likely those customers are to stick around.

Changes in net interest income can significantly mask the underlying strength (or weakness) of a bank’s business, in some cases for years. Indeed, in the recent past a full range of banking "experts" have greatly underestimated the negative impact of falling net interest income (and thus greatly overestimated banks’ earning power) as the interest-rate environment became unfavorable, leading to earnings shortfalls and highlighting poor capital allocation.

If policy rates in Europe and North America remain at zero for "an extended period" as I believe they will, banks will face a secular period of lower return on equity or higher risk profiles. Taking on risk means blow-ups like the JPMorgan Chase London whale trade, which makes a bank a riskier investment. The other option for equity investors is to accept lower return for the foreseeable future as this is not a cyclical issue, but a secular one.

As daunting as this environment is for investors in bank shares, it is even more daunting for bond investors. Fixed income investors tend to be risk averse and are investing with the expectation of a return of 100% of their capital plus interest. Bank bond investors have these expectations perhaps more than other corporate bond investors because of the implicit government backstop that banks have enjoyed as demonstrated with the bailouts during the financial crisis.

However, the ECB’s shift toward private participation in bank bailouts means this backstop has eroded significantly. What this, in effect, signals is that euro bank bondholders will have to share in losses once equity capital is wiped out. With this taboo now broken, US bank bond investors should expect the same treatment.

What does this mean? In the context of banks’ higher risk profile, lower return on equity and still fragile balance sheet, it could mean significant principal losses during the next downturn. In terms of credit, the cycle is near the peak. All indications are that investors are loading up on leveraged commercial mortgage backed securities in particular. When the cycle turns, likely a number of banks will be caught out and take losses on these riskier investments as well as legacy toxic assets already on their balance sheets. When they get into trouble, bondholders will be subject to greater losses than they now realise.

Likely, when the prospect of losses is made plain for just one large issuer, it will trigger asset class contagion and an across the board selloff in bank bonds. Therefore, it pays to examine your portfolio and gauge the risk of the bank bonds in it in anticipation of these events.