Original Link| ProfitableTrading by Amber Hestla
As we get deeper into the fourth quarter, one of the biggest stories dominating the financial headlines will be interest rates, and the fact that they appear to be headed higher.
While investors have been talking about this same story for the past few years, there’s a good reason: The fed funds rate is the interest rate banks and major depository institutions charge each other for loans (which banks sometimes need to meet the Federal Reserve’s deposit requirements).
This rate is only changed at regular Fed meetings held every six weeks.
The rate is widely followed because it is the benchmark for a number of other rates. Due to its importance, large banks and other financial market participants hedge their exposure to interest rates.
For now, the Fed has set the rate at 1% to 1.25%. The futures market is already pricing in a rate of 1.25% to 1.5% after the next meeting, which is scheduled for Dec. 13.
As rates go up, there will be winners and losers. Unfortunately, consumers could be among the biggest losers. Many credit card companies tie their rate to Fed policy, and car loans and mortgages are also likely to cost more.
On the other end of the spectrum, we have banks, which should benefit from higher interest rates. One of the most important sources of a bank’s profits is the margin it charges on loans. This is the difference between the rate the bank pays to borrow money and the rate it charges when it lends money. At its most basic level, a bank’s business model is to borrow money at short-term rates and lend it out at higher, long-term rates.
As rates rise, banks can increase the size of their margins, and studies have found that higher rates boost banks’ profits. The average net interest margins are higher in high-rate environments than in low-rate environments. Profitability, measured by return on assets, is also higher in high-rate environments.
This Banking Giant Is Turning Itself Around
With rates almost certain to rise, this means that banks are among the best investments in the market right now. Bank of America (NYSE: BAC) offers a high-income opportunity in the sector.
Bank of America serves clients of all sizes, from the small individual consumer all the way up to corporations and even governments. It also offers a range of services, including banking, investing, asset management and other financial and risk management products. In total, Bank of America has assets of $2.25 trillion and deposits of $1.26 trillion.
The company’s presence across the country is widespread, with approximately 4,500 retail financial centers and 16,000 ATMs. Digital banking serves approximately 34 million active users, including 23 million mobile users.
Over the past few years, Bank of America has taken steps to diversify its operations, ensuring it can withstand potential financial crises. Today, the company’s U.S.-based banking business accounts for 37.5% of total revenue while global banking (operations outside of the United States) accounts for 22% of sales. Global Wealth & Investment management, the company’s private wealth management segment, represents about 21% of revenue, and Global Markets — the division responsible for trading, market-making, financing, securities clearing, settlement and custody, and risk management — provides about 19% of the company’s revenue.
As a result, the company has changed from a highly leveraged, risky bank to a relatively stable, conservative bank. But while stability often goes hand-in-hand with slow growth, there are two potential catalysts for Bank of America to boost growth.
One of those two catalysts is higher interest rates, and the positive impact that should have on BAC’s bottom line. In fact, the results from this are already showing up in the income statement as an improvement in the company’s net interest income.
The second catalyst is the company’s focus on reducing expenses. Management launched a cost reduction effort in 2011, known as Project New BAC. The results were immediate. By the end of 2014, operating expenses were reduced by $8 billion and the trend towards lower expenses continued for the next two years. Expenses have remained constant for the first half of this year, demonstrating the culture of the company has been changed.
Regulators agree that BAC is moving in the right direction. One reason we know this is because large banks have to secure approval for their dividends and buybacks every year, and, this year, regulators approved a 60% dividend hike and $12 billion share repurchase authorization (through the third quarter 2018).
BAC is an excellent investment in the current, high-risk market environment. Despite all of the positive developments in the past few years, Bank of America remains undervalued when compared to its peers. Its current price-to-earnings (P/E) and price-to-book (P/B) ratios are lower than the industry averages. Its dividend yield is also lower than average.
Given the relative stability among big banks, I believe the industry — and BAC in particular — should be valued for its safety, and its ability to generate income for shareholders. But at a yield of 2%, I wouldn’t blame the average investor for wanting more.