sshepard
By Andrew C. Arbesman, CFA, CPA
We believe the group trades too wide relative to similarly rated industrial credits
Credit fundamentals for U.S. banks remained robust in the third quarter as higher rates, loan growth and benign asset quality boosted bank profitability despite weak capital markets revenues. Solid capital ratios were a credit-positive theme in the quarter as many large banks retained capital and managed down risk-weighted assets to meet higher capital requirements at the start of Q4, with some banks facing even higher capital requirements on January 1. Overall, bondholders should be happy with bank earnings, as they demonstrated the resilience of the sector’s credit fundamentals.
Asset quality for banks remained strong, with charge-offs moving up only modestly in the quarter. Consumer spending slowed but remained robust amid weakening economic indicators and inflationary concerns. Importantly, consumers’ excess cash buffers, which had been established during the pandemic, remained well above pre-COVID levels. Bank of America, for example, noted that customers who had less than $2,000 in their bank accounts at the start of the pandemic had on average five times that amount today. Similarly, commercial asset quality remained strong with nonperforming loans staying at low levels.
Despite healthy consumers and corporate customers, banks continued to pivot away from reserve releases and built reserves on the back of higher loan growth and changes in economic assumptions. The reserve builds appeared gradual and prudent given elevated uncertainty, and are likely to benefit the banks should the U.S. economy enter a recession in the near to medium term.
Unfortunately, senior bank spreads have failed to mirror the sector’s strong credit fundamentals in 2022. We attribute much of this disconnect to the amount of bank issuance at the start of the year, which weighed on valuations. Adjusted for duration and ratings (10-year; A-rated), U.S. banks traded +8 basis points wide of industrials at the start of the year. This has now increased to +42 basis points, which is a level witnessed in April 2020 – in our view, far too wide for the healthy capitalization, strong liquidity/funding profile and stable asset quality of the sector. Spreads look attractive and may compress as we head into year-end with supply moderation and industrials’ revision of earnings expectations tied to a weaker macroeconomic environment.
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