Bank Stocks Are Offering Yields of Nearly 4%. But Are They Safe?

The stock market seems to be shrugging off COVID-related economic pain. Well, some parts of the stock market. And it's not just industries like airlines and hotels that are struggling, banks are also having one their worst years since recovering from the 2008-2009 financial crisis.

The year 2020 is ugly indeed for the nation’s banks, and not for one particular reason. Instead, they are dealing with multiple layers of misery: Rock-bottom interest rates, the threat of widespread loan defaults, and a pandemic-ravaged economy with Covid-19 continuing its spread, just to name a few.

The result is one of the worst-performing areas of the market. Year-to-date the sector-tracking KBW Nasdaq Bank Index has sunk roughly 36%, while the S&P 500 is actually up around 4%. If the year ended today, that would make for the “worst year for relative bank stock performance on record,” wrote Barclays equity analyst Jason Goldberg in a recent research note.

Of course, it is precisely when most investors have given up on a sector, that stocks become intriguing long-term buys. So if you are concerned about sky-high price-earnings ratios elsewhere in the market – electric carmaker Tesla, for instance, is around 1,000 – well, wander over to the clearance rack and check out some forgotten financials.

“Banks are attractive as value stocks today, and they tend to do well when there is confidence in a cyclical rebound in the U.S. economy,” says Ken Leon, director of equity research for independent advisory CFRA. “They’re undervalued, so for those investors who are looking out 12 months, they could be very interesting investments.”

To wit: JPMorgan Chase, the nation’s largest bank, is sitting in the bargain bin with a forward P/E ratio of 10.5. Other prominent names are similarly valued: Bank of America at 11.1, Wells Fargo at 11.2, and Citi at an eye-opening 6.9.

Leon’s top picks at CFRA: Those financials with the highest exposure to the capital markets, like Goldman Sachs and Morgan Stanley. Among players with broader involvement in areas like commercial and consumer loans, he likes JPMorgan Chase.

Meanwhile Barclays’ Goldberg has “overweight” ratings on a large number of banks – not only Bank of America, JPMorgan Chase and Citi, but Capital One Financial, M&T Bank, Fifth Third Bancorp, State Street, US Bancorp and SVB Financial Group.

If selecting individual financial stocks feels like too much risk, look instead to funds that house hundreds of names, like Fidelity MSCI Financials, Vanguard Financials, or Financial Select SPDR.

Financial crisis flashbacks

Part of the dynamic at play here, is investor PTSD stemming from the financial crisis of 2008-2009. At that time, sketchy mortgage-backed products and extreme leverage meant that banks had to constantly slash asset values on their books, sending investors into a panic. Some institutions didn’t survive, and others were sold for pennies on the dollar.

But it’s important to recognize that this era isn’t a mirror of that period. Bank oversight isn’t perfect, of course — but corporate balance sheets are in much better shape than back then, with occasional “stress tests” (including a fresh round by the end of the year) helping to ensure that banks are sturdy enough to withstand serious economic shocks.

“Balance sheets are very strong today, because they have myriad different ratios they have to meet,” says CFRA’s Leon. “They are more heavily regulated today than they were back then — in fact they probably have too much capital right now.”

That being said, there’s no escaping the fact that banks are fighting through major headwinds in 2020. Most notably the fact that interest rates are near zero, which makes it highly challenging for lenders to earn much money. Average 30-year fixed mortgages, for instance, are below 3% and bumping all-time lows.

That environment doesn’t look to be changing anytime soon. The Federal Reserve, at its recent Open Market Committee meeting, again stressed its determination to keep rates low for the foreseeable future — which likely means the next couple of years.

Get paid while you wait

Essentially it’s a wait-and-see period for the economy, as we keep an eye on vaccine news and hope the American consumer can emerge on the other side of the crisis without too much damage.

So as long as we’re waiting, we might as well get paid for it, in the form of dividends. JPMorgan Chase is yielding 3.8%, for instance, Bank of America and Morgan Stanley are throwing off 3%, and Citi just over 2%. In fact the average yield of banks covered by Barclays’ Jason Goldberg is 3.6%, which is more than 5 times the rate offered by current 10-year Treasury notes, he points out.

In an era when bonds and savings accounts are yielding almost nothing, dividend-yielding bank stocks could be an attractive option to generate cash flow, especially for investors nearing or in retirement. (A caveat: Don’t expect any dividend growth in the near term. As the Federal Reserve Board tabulates the results of its latest stress tests, banks are in a holding pattern with both dividends and share buybacks.)

Beyond just the income potential, there is share-price upside for patient investors. If anything is certain in this life, it’s that one day the economy will rev up again, inflation will tick up, interest rates will rise along with it, and banks will find themselves the beneficiaries of an expanding economy once the current crisis has passed.

For steely value investors, the time to bet on financials is not after that expansion is well underway, but precisely when things look darkest.

“Barring a severe second rise for Covid-19, the outlook for 2021 and ‘22 should be better,” says CFRA’s Leon. “If jobs stabilize and unemployment comes down, there could be a V-shaped recovery through 2021. Probably by the end of this year, some of the negative factors that have kept bank stocks underperforming should abate – and there could be a big reversal.”

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