Bank stocks are known to thrive in a rising interest rate environment because of the perception that higher interest rates lead to greater earnings growth.
When interest rate increases, margin spreads also tend to expand, as interest income from loans and investments rises faster than interest expense paid to depositors.
The higher the increase in interest rate, the greater the net interest income banks are supposed to earn.
But market history shows that bank stocks, in general, tend to decline every time interest rate increases.
If we will look at how the financial sector index performed in the past 22 years, we will find that bank stocks are negatively correlated with changes in 10-year Philippine bond yield 62 percent of the time.
Rising rates expose banks to volatility risks that create a potential mismatch in the valuation of financial assets and liabilities.
For example, we know that banks typically invest and loan out money for a very long period, which they finance with short-term borrowings and demand deposits.
Because the average maturity of financial assets is longer than liabilities, an increase in interest rate from unexpected fluctuations can cause the value of assets to decline faster than its liabilities, resulting in investment losses.
Rising interest rates also increase risk of defaults that may arise from borrowers’ failure to make the required payments, which can negatively affect the quality of a bank’s assets, leading to higher credit loss provisions and lower net income.
Gauging risk
One way we can measure the riskiness of bank stocks is by comparing return of equity (ROE) with its cost of equity (COE).
If ROE is higher than COE, it will mean that the bank is creating value for its shareholders, and if ROE is less than COE, it means that shareholders are at risk of losing value.
The COE of a bank, which is the minimum return that investors expect to earn from investing in the stock, is driven mainly by the sum of the prevailing interest rate and its risk premium.
For example, if we want to estimate the COE of Union Bank, we can simply get the sum of the current 10-year Philippine bond yield of 6.03 percent and the stock’s volatility premium of 1.65 percent to get 7.7 percent.
If we compare this with the bank’s ROE of 12.92 percent, we will get a positive spread of 5.22 percent.
Because ROE is greater than COE, the bank will have an ROE-to-COE ratio of 1.68, which fairly reflects its current price to book value (PBV) ratio of 1.7.
Now, imagine if interest rate increases with the 10-year bond yield rising to 7.03 percent, Union Bank’s COE will also increase, lowering its ROE-to-COE ratio to 1.49.
The decrease in the ROE-to-COE ratio should eventually correct the bank’s share price until it reflects a similarly lower PBV ratio.
Amid the pandemic
If we look at average ROE-to-COE ratio of the bank stocks belonging to the financial sector index, we will find that the trend has been declining for the past two years from 1.28 in 2019 to 1.22 last year.
We note that, although ROEs have slowed down during the pandemic, most bank stocks had positive spreads then due to the low-interest rate regime, which helped them lower their average COEs.
But today, rising interest rates have been increasing the average COEs of bank stocks beyond their ROEs, pushing down the sector’s average ROE-to-COE ratio to only 0.84. This fairly reflects the current average PBV of the banking sector at 0.88, which is why most bank stocks today are trading below book values at 12-percent discount.
The rise in interest rates may be initially good for bank stocks, as the economy tries to recover from the pandemic, but if interest rates continue to go up as inflation expectation increases, the higher risks will drag down bank stock prices and returns. INQ
Henry Ong is a registered financial planner of RFP Philippines. Stock data and tools were provided by First Metro Securities. To learn more about investment planning, attend the 95th batch of RFP program this May 2022. To register, email info@rfp.ph or text at 0917-6248110.