Bond Selloff Adds to the Pressure on Regional Banks
4 min read . Updated: 11 May 2023, 11:15 PM IST 
PremiumRising yields on debt threaten higher borrowing costs for lenders
Investors are demanding higher yields to own the bonds of regional banks, threatening to further pressure lenders that are already being hit by rising deposit costs.
The extra yield, or spread, on regional-bank bonds over U.S. Treasurys has risen in many cases by about 2 percentage points or more since early March, when the failures of Silicon Valley Bank and Signature Bank spurred a broad investor retreat from all but the largest U.S. banks.
The spread widening is based on a sampling of actively traded bonds of lenders with about $150 billion to $220 billion of assets, such as Columbus, Ohio-based Huntington Bancshares and Buffalo, N.Y.-based M&T Bank. Banks in that group are small enough that concerns have emerged about their health but still large enough to have significant amounts of bonds outstanding.
By contrast, the spread on 10-year JPMorgan Chase bonds increased by only around 0.1 percentage point over that span, according to MarketAxess, reflecting in part the firm’s financial strength and the perception that the U.S. wouldn’t allow a bank so large to fail.
After the bank failures in March, federal regulators have signaled that they eventually could force banks with as little as $100 billion in assets to issue more long-term bonds, subjecting them to similar requirements as the giant banks now deemed systemically important.
The purpose of such rules is to create a buffer of debt that can be converted into equity if a bank becomes insolvent, reducing the need for taxpayer-funded bailouts. But the impact for regional banks could be selling bonds into a market that isn’t eager to purchase them.
“Spreads are wider, so funding costs are up, rates are up, and they need to raise more of this stuff," said Andrew Arbesman, a senior fixed-income research analyst covering banks and insurance companies at Neuberger Berman.
The prospect of higher funding costs, Mr. Arbesman said, is one reason why “a lot of equity analysts are negative on the regional banks, because they’re seeing that they’re not going to be able to produce the returns as they did in the past."
Higher yields on regional-bank bonds won’t immediately translate to higher borrowing costs for regional lenders. Their eventual impact could also be modest given that regional banks would be overwhelmingly funded by deposits rather than bonds even after new regulations are applied.
But it is clear higher borrowing costs drag on midsize banks, especially when many are already having to increase deposit rates to hold on to customers.
Take Huntington, which had about $169 billion in interest- or dividend-earning assets in the first three months of the year along with $8.8 billion of bonds outstanding at the end of the quarter. If the bank, over time, replaced all of its bonds with new bonds that paid 1.5 percentage points more in interest that would reduce its annual net interest income by about $130 million.
For context, the bank generated about $5.3 billion in net interest income last year and $1.4 billion in its most recent quarter. That latter figure was up 23% from a year earlier, thanks to rising rates on its floating-rate assets but down almost 4% from the previous quarter, in part because of rising deposit costs.
According to a recent report by Barclays, Huntington could also need to issue as much as $6 billion in new bonds to satisfy expected regulations. Assuming it issued bonds at current rates, there could be some further margin erosion, though the impact could vary depending on how Huntington invested the proceeds from the bonds. Huntington could also need to issue as little as $1 billion, according to Barclays, and the rules could be structured so banks can issue bonds over an extended period.
Many investors and analysts, meanwhile, say that regional-bank bonds are oversold, noting that most banks have reported relatively stable deposit levels despite the recent market turmoil.
As of Tuesday, Huntington’s 5.023% bonds due in 2033 were trading at just under 90 cents on the dollar, translating to a roughly 6.6% yield and a spread to Treasurys of around 3.1 percentage points, up from around 1.7 percentage points before Silicon Valley Bank’s failure. Its more actively traded 4% notes due in 2025 were trading at an even larger spread of about 4 percentage points. Bonds of its peers, such as M&T Bank and Providence, R.I.-based Citizens Financial, have been trading at similar levels.
Mr. Arbesman, of Neuberger, said he thinks there is a chance that spreads on regional banks eventually return all the way back to where they were before Silicon Valley Bank’s failure. Having covered banks through different crises, including the housing bust of the late 2000s, Mr. Arbesman said the current situation amounts to “one of the biggest gaps between perception and reality in the sector’s history."
Still, even analysts who have been bullish on regional-bank bonds caution that perception could ultimately shape the fundamentals for lenders.
Jesse Rosenthal, a senior analyst at the research firm CreditSights who has strongly recommended buying regional-bank bonds, said that banks continue to “look very, very solid."
Even so, he said, “if the sentiment continues to be so bad that we actually start to see a new round of massive deposit outflows, that’s going to create a problem for the best-run bank."