Underwater Bond Holdings Will Squeeze its Net Interest Margin

Key Takeaways

• Banks are being forced to offer higher rates to keep deposits.
• Lending will remain slow, which will squeeze net interest margins.
• BofA also has substantial capital tied up in low yielding securities.
• Net income growth will therefore be very low.
• However, BofA’s assets will benefit from lower rates and retained earnings
• Price multiples will rise a little but be capped by low growth.

Catalysts

Industry Catalysts

A Price War for Deposits is Developing in the Sector

Now that interest rates are at meaningful levels, account holders are looking to maximize yields. They can shop around for the best deposit rate, or they can invest in medium term money market instruments. This is forcing banks to pay higher rates on deposits to attract or keep depositors. JP Morgan’s Jamie Dimon said he expects competitive pressures will force banks to offer higher rates to savers.

For BofA the proportion of interest bearing deposits is already rising, and this trend is likely to continue. If BofA doesn’t increase rates for savers, depositors may seek out alternatives, and if it does increase rates on deposits, it will see downward pressure on its net interest margins and operating margins. 

BofA Interest Bearing vs Non-Interest-Bearing Deposits Source: BofA Website

High Rates and a Real Estate Stalemate Will Cause a Rapid Slowdown in Loan Growth

Higher interest rates are resulting in slower loan growth, as many parts of the economy are already experiencing a slowdown. 

The real estate market is also deadlocked: home prices and mortgage rates are both beyond the reach of most would-be buyers, but homeowners with low rate mortgages are reluctant to move, as this would cause a substantial increase in monthly payments. 

Source: Zillow

We see in the above chart, the number of monthly For-Sale listings on Zillow has been declining year-on-year, with the latest seasonal uptick also being more subdued than in previous years, hinting at less activity within the property market caused by this apparent stalemate.

Since 2007 over 90% of US mortgages have carried fixed rates, so this reluctance to sell to avoid facing higher rates applies to the majority of current homeowners, and not that many existing US mortgages are impacted by these rate rises.

The commercial real estate market is also in a stalemate, as investors and lenders are trying to avoid realizing losses.

All of this paints a bleak picture for lending. With less activity on both the buyer side due to high interest rates and on the sellers’ side due to the number of homeowners with lower fixed mortgage rates, banks’ loan growth is likely to grind to a halt. I believe banks will struggle to capitalize on the current level of interest rates.

Company Catalysts

Paper Losses Eating up Earnings Potential

BofA disclosed unrealized losses of $131.6 bln in the latest results. These are mark-to-market losses on held to maturity securities (HTM). BofA is well capitalized, so these losses are unlikely to be realized or affect the bank’s solvency as the bank also holds $176 billion in available for sale securities and $352bn in cash and equivalents. 

But these HTM securities are tying up capital while generating low yields, meaning it can’t deploy the capital elsewhere, unless it wants to realize a huge one off loss to redeploy it elsewhere.

BofA Cash and Securities and MtM P&L    Source: BofA Website

The Net Interest Margin Will Inevitably be Squeezed

BofA’s opportunity to increase, or even defend its net interest margin, is being squeezed on both sides.

On the asset side:

• The slowdown in lending offers the bank limited opportunities to take advantage of higher rates. In the event that rates fall, lending may pick up, but the yield on new loans will be lower.
• The HTM portfolio is locked into low yields, which also limits the opportunities to take advantage of higher rates.

On the liability side:

• BofA will need to pay higher rates to prevent deposits moving to competitors or money market instruments or funds.

I believe this situation will result in BofA’s net interest income falling and then recovering slightly over the next few years. I think it will be about the same in 2028 as it has been over the last 12 months ($57.7 billion).

Earnings Growth Will Come from Lower Expenses and Modest Growth in Fee Income

BofA’s fee-based revenue has been flat over the last decade and there are very few catalysts that would suggest a significant improvement. However, a peak in interest rates is likely to lead to some improvements in fees from Investment Banking (due to increased M&A) and asset management. 

Declining rates will provide more certainty to companies making acquisitions, and make acquisitions cheaper to finance. Declining rates should also provide a catalyst for fund flows, and lead to higher performance fees from bond funds.

Additionally, BofA has been reducing headcount and increasing the digitization of the bank’s operations and interaction with customers. These initiatives will improve efficiency and reduce costs, leading to slightly lower operating costs.

BofA Headcount     Source: BofA Website

Net margins have been in the 20-30% range since 2017, and I expect that as operating costs decrease, this, along with fee income growth will help provide a bit of support to margins that are otherwise going to be pressured by lower lending and loan growth.

Bank of America Revenue and Earnings History - Simply Wall St

Improved Asset Values Will Be More Impressive Than Earnings Growth

Although I believe earnings growth will be in the low single digits, BofA’s book value (assets less liabilities) is likely to increase for the following reasons:: 

• Retained earnings still amount to ~9% of equity, which is added to the value of assets on the balance sheet.
• As bond yields fall, the mark-to-market loss on BofA’s HTM securities will begin to reverse. This will also result in higher asset values. 
• Deposits, and therefore liabilities, are likely to remain flat.

This leaves room for a meaningful increase in the book value per share. I think investors will still focus on earnings growth, but the higher book value would translate to a higher share price, even if the price-to-book ratio remains at current levels (~0.9x). I nevertheless do expect the price-to-book ratio to increase slightly.

Assumptions

Long Term Interest Rates will Average 3.5% Through 2028

I’m assuming that long-term interest rates and bond yields will normalize at around 3.5% over the next five years.

Earnings Growth Will Disappoint

Slow loan growth and capital tied up in HTM securities with low yields will provide little opportunity to improve interest income. Competition for deposits while interest rates remain at higher levels will therefore cap net interest income growth at 0.5%/year. 

I expect modest increases in non-interest revenue (+ 1%/year) and lower expenses (-1%/year) will result in pre tax income increasing at 3.1%/year through 2028.

BofA’’s effective tax rate has been as low as 5.8% in recent years. This was a result of renewable tax credits struck under the Inflation Reduction Act. I’m assuming the tax rate will normalize at 15% as further deals have not been announced, and competition for similar deals is likely to increase.

Therefore:

• Net interest income for FY 2028 will be $57.6 bln, which is the same as the last 12 months.
• Non Interest revenue for FY 2028 will be $45.6 bln, up from $43.5bln in the 12 months to September 2023. 
• Meaning, I expect revenues to grow 1.3% per year to reach $103.2bln.
• Operating expenses for FY 2028 will be $60.4 bln, down from $63.7 bln in the 12 months to September.
• Net income for FY 2028 will be $32.03 bln, up from $28.9bln today

BofA’s Equity Value Will Increase by 39%

Common shareholder equity will increase from the current level of $258 billion to $353 billion.

This is a conservative estimate based on: 

• Retained earnings of $15 billion/year, which would still be achievable even if earnings fall by 20%.
• $26 billion of the mark-to-market losses reversing, or 20% of the current unrealized loss.

Share Buybacks will Continue at a Slower Pace

BofA’s outstanding share count has been falling substantially in recent years. However, I believe buybacks will continue at just 0.5% annually as the bank manages its liquidity. I’m forecasting the total outstanding shares to decline to 7.8 billion from 8.15 billion today

Price Multiples Will Rise, But Remain Below Long Term Averages

BofA’s price multiples will revert toward the mean, but disappointing growth means they won’t trade above long term averages. The price/earnings and price/book ratios will therefore remain below their five year averages of 12.5x and 1.1x respectively.

BofA Historical PE Ratio     Source: Simply Wall St

Risks

Interest Rate Sensitivity Means Higher Rates Could Derail The Narrative

This narrative is particularly sensitive to interest rates and economic growth. I’m assuming that long term rates will average around 3.5% over the next five years. I’m also assuming moderate economic growth after a few quarters of low or slightly negative growth in 2024.

If rates remain above 4.5% for an extended period, BofA faces a very real risk of either:

• Losing deposits to other interest bearing alternatives, in which case they may have to realize some of their unrealized losses, or,
• Paying higher rates on deposits which would result in an even lower net interest margin.

If BofA sources further renewable tax credits, the effective tax rate could remain below my estimate of 15%. But I’m assuming that with competition these credits will be less lucrative by 2028.