It continues to seem likely that the Federal Reserve will start raising interest rates later this year, which has some investors thinking bank stocks are a good bet. But be careful when it comes to the interest rate/bank stock relationship, Validea CEO John P. Reese says.
“Yes, banks make money by borrowing at one rate and lending at a higher rate,” Reese writes in his latest Forbes.com column. “This is particularly true for smaller, regional banks, which don’t have the big investment management arms that the likes of Bank of America (BAC) or Citigroup (C) have. The bigger the spread between the rate at which they borrow and the rate at which they loan, the higher their profits should be, all things being equal. Tiny spreads have been part of the current low-interest-rate environment, hampering banks — and quite possibly the broader economy.”
But, Reese notes, the reality is not as simple as bank profits going up when interest rates rise. “A 2013 Oppenheimer study found, for example, that over the longer-term, rate increases can lead to risks like ‘funding squeezes against long-dated assets, like Jumbo mortgages and MBS; the potential for a ‘nuclear winter’ in terms of corporate debt issuance; and positioning losses, either in direct trading portfolios or customer portfolios that may be funded with margin debt,'” he notes, adding, “Then there is the fact that interest rates are far, far from the only factor influencing bank stocks at a given time. All sorts of economic factors, valuations, and a myriad of company specific issues all push and pull on bank stock prices, and sometimes their impacts will dwarf those of interest rates.”
As a result, investors shouldn’t just haphazardly pile into bank stocks in anticipation of rising rates, Reese says. He says they should look for only the most fundamentally and financially sound banks in the market. Reese uses his Guru Strategies, each of which is based on the approach of a different investing great, to find a trio of regional bank stocks that look attractive. Among them: National Penn Bancshares.