When Rates Rise, So Do These Stocks

By TradeSmith Editorial Staff

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Higher interest rates plus supply chain snarls could wreck markets.

Yet that’s exactly the environment that favors regional banks.

You see, regional banks typically make MORE money when interest rates are high.

However, that’s only true if they lend money.

So, who would want to borrow at higher interest rates?

Manufacturers, that’s who.

COVID-19 showed us that we rely too much on foreign sources for supplies, including everything from steel to microprocessors. Plus, conglomerates like Amazon continue to expand their reach by adding more fulfillment centers.

Even farmers are looking to expand their production.

So why are regional banks better than big household names like JPMorgan and Citigroup?

More importantly, how do you find the best ones for your portfolio?

That’s what I want to discuss today.

But before we get there, let me explain how banks make better margins when interest rates are higher.

Understanding Net Interest Margin

In my recent seasonality article, I touched on a concept known as net interest margin.

Banks make money in two ways: fees and net interest margins.

Fees include everything a bank charges for the different services it provides, from loans to wealth management.

Net interest margin is the profit a bank makes on the difference between the rate at which it borrows money and the rate at which it lends.

When you park money at a bank in any of their accounts, whether it’s a certificate of deposit (CD) or savings, the bank pays you a certain interest rate.

The rate it pays you is based on short-term interest rates. The best rate available today for a typical savings or money market account is 0.60%.

However, banks lend at longer-term interest rates.

The difference between the two rates is known as the net interest margin.

Here’s a quick example (note, the numbers here do not reflect actual rates):

  • Let’s say a bank charges 3% above the five-year U.S. Treasury rate, which sits at 1.25%.
  • A five-year consumer CD pays out 0.5% more than the two-year U.S. Treasury rate, which sits at 0.5%.
  • The bank’s net interest margin is (3% + 1.25%) – (0.5% + 0.5%) = 4.25% – 1% = 3.25% on the money it lends.
Now, when interest rates rise, long-term rates tend to move up more than short-term rates. How might that play out in the previous example?

  • Both the five-year U.S. Treasury rate and the two-year U.S. Treasury rate increase by 50%.
  • That makes the two-year U.S. Treasury rate 0.75% and the five-year U.S. Treasury rate 1.875%.
  • Now, the bank’s net interest margin is (3% + 1.875%) – (0.5% + 0.75%) = 4.875% – 1.25% = 3.625% on the money it lends.
That may not seem like much. But when you consider that regional banks have assets of $10 billion to $100 billion, that extra 0.375% means an extra $37.5 million to $375 million for the bank.

Why Regional Banks are in the Best Position

If regional banks are defined as banks with assets between $10 billion and $100 billion, wouldn’t even larger banks make more money?

In total, yes, they would.

Proportionally and on a per share basis, they would not.

For example, in 2020, Wells Fargo & Co. (WFC) derived about 55% of its income from net interest income. Compare that to Huntington Bancshares (HBAN), a regional bank based out of Ohio, which got 67% of its revenues from net interest income.

Typically, regional banks earn a higher percentage of their revenues and income from net interest margin than large national banks, which thrive on things like investment banking and trading.

Additionally, regional banks are more likely to make commercial loans to local industries. So, a Texas regional bank is more likely to loan to oil and gas companies, while a Florida regional bank will skew more toward hotels and entertainment.

Analyzing a Bank’s Portfolio

Now, I want to find regional banks with more exposure to commercial loans, and specifically industrial space and manufacturing.

This part can take a little bit of time, but I’ve done a lot of the legwork for you.

Let’s go back to Wells Fargo and Huntington Bank.

First I want to see the percentages of commercial and residential loans.

If you break down their assets (loans show up as assets on a bank’s balance sheet), commercial loans account for 54.1% of Wells Fargo’s total loans.

Only 49% of Huntington’s loans are commercial.

But check out the loan portfolio of Heartland Financial USA (HTLF), a regional bank based out of Dubuque, Iowa.

Nearly three-fourths of the loan portfolio is tied to commercial and industrial real estate, and 7% is tied to agriculture.

Another factor to consider: HTLF gets a whopping 82% of its income from net interest.

That’s exactly the kind of portfolio I’m looking for in the environment we talked about.

Residential real estate loans only make up 9% of the total portfolio. That’s fine by me, since home inventory is relatively low.

KeyCorp (KEY) is another regional bank with a heavy commercial portfolio that makes up 70% of its total loans. However, only 55% of its income comes from net interest. That might make a better choice if you want to hedge your bets.

According to TradeSmith Finance, both HTLF and KEY are in the Green Zone and have positive momentum.

And the icing on the cake: Heartland Financial pays a 2.13% dividend yield, while KeyCorp pays a whopping 3.34%.

As always, I welcome your questions and feedback. You can reach me here. I can’t respond personally to every email, but I read them all.