Regional Banks Embrace Bond Restructuring to Prepare for Rate Cuts

In the aftermath of the Silicon Valley Bank failure, more US regional banks are taking a bold step that was unthinkable just a year ago: selling underwater bonds at a loss. This strategic move, however, is not driven by the need to pay depositors, as was the case with Silicon Valley Bank. Instead, these regional banks are preparing for the anticipated interest rate cuts from the Federal Reserve.

Positioning for the Impending Rate Cycle Shift

Locking in Yields Ahead of Rate Cuts

Regional banks, including the likes of PNC Financial Services Group, Truist, Regions, and Webster, have announced bond sales in recent weeks. These sales are not driven by the need to pay depositors, as was the case with Silicon Valley Bank. Instead, the banks are using the proceeds to purchase new bonds with higher yields, anticipating that the Federal Reserve will start cutting rates as early as September."If they've got extra cash, bank treasurers who think we're at the top of the cycle may decide to go ahead and lock in long-duration bonds so that once we're in a lower-rate environment they still have a decent yield," explains Feddie Strickland, an equity research analyst with Hovde Group.PNC, for instance, took a $500 million loss on its bond sales but reinvested the proceeds into securities with yields approximately 400 basis points higher than the ones sold. This move has raised the bank's confidence that it will reap a record amount of net interest income next year, a critical source of revenue for regional banks.

Navigating the "Swoosh" of Interest Rates

PNC's CFO, Robert Reilly, described the bank's strategy as "locking in some of the swoosh," referring to the anticipated trajectory of interest rates, which is expected to resemble the iconic Nike logo. By realizing bond losses now, these banks are positioning themselves to benefit from the anticipated rate cuts in the coming months or years.Truist, another regional powerhouse, took a $5.1 billion after-tax loss when it sold bonds yielding a mere 2.80%. However, the bank used the proceeds to purchase new bonds with a yield of 5.27%, expecting a 2% to 3% increase in its net interest income next quarter.

Balancing Losses and Profitability

Not all regional banks are making such bold moves. The direction of interest rates remains a challenge for many, as they grapple with high deposit costs, troubled borrowers, and lackluster profits.Regions Bank, for instance, took a $50 million pre-tax loss to replace approximately $1 billion of bonds, but its CFO, David Turner, called the "repositioning" move a "good use of capital" and said the bank may look for more opportunities to sell bonds.Similarly, Webster Bank, based in Stamford, Connecticut, took a $38.7 million after-tax loss from realizing bond losses. However, the bank lowered its net interest income expectations for the year, citing higher deposit costs and lower yields from its loans.

Weathering the Commercial Real Estate Headwinds

The challenges facing regional banks extend beyond just interest rate dynamics. The exposure to commercial real estate weaknesses has also been a concern, as exemplified by the recent performance of New York Community Bancorp.The commercial real estate lender reported a second-quarter loss, the sale of a mortgage-servicing business, and an increase in its reserves for future loan losses. Its stock price has been one of the worst-performing in the industry, reflecting investors' ongoing concerns about the sector's vulnerabilities.

Navigating the Uncertain Path Ahead

The hope for many regional banks is that as interest rates come back down, the loans on their balance sheets will recover their value, and deposit costs could also drop. However, the path forward remains uncertain, and the profitability story will vary significantly between individual banks."When the rate cycle changes is going to have a big impact on what the profitability story looks like," said Moody's Ratings analyst Megan Fox.By proactively restructuring their bond portfolios, regional banks are taking a calculated step to position themselves for the anticipated rate cuts. This strategic move, while not without its risks, aims to secure a more favorable yield environment and strengthen their financial footing in the face of the evolving market dynamics.