With Treasury yields soaring, US banks are caught in a dilemma: should they sell the bonds on their books at the cost of huge losses, or keep enduring the pressure of unrealized paper losses? Both options come with a hefty price. Selling means taking an immediate financial hit, while holding on allows losses on the balance sheet to keep piling up, weakening some financial metrics and limiting dividend payments and buybacks to shareholders.
"If rates stay elevated, or if long-end rates steepen further, that drag will extend even more and continue to weigh on tangible net worth, and for some banks, it will also create pressure on regulatory capital," said Brian Mulberry, chief market strategist at Zacks Investment Management, which holds shares in several banks.
Banks typically use an accounting measure known as Accumulated Other Comprehensive Income (AOCI) to record changes in the value of bonds they may sell before maturity. It reflects gains or losses that have not yet been realized through an actual sale. According to S&P Global Market Intelligence data, US banks' AOCI balances remained deeply negative in the second quarter of this year at $156.64 billion, though this was a big improvement from 2023 levels.
And that was only before the third quarter. The 10-year Treasury yield, the benchmark for global borrowing costs, posted its biggest quarterly jump since 1994 in the third quarter, which could deepen US banks' unrealized losses further. In the three months ended September 30, Bank of America Corp (NYSE: BAC) saw its accumulated other comprehensive loss widen by more than $3 billion from the end of June. By the end of September, unrealized losses on the bank's bond portfolio reached $109 billion, up from $85 billion at the end of June. Most of these securities fall under the "held-to-maturity" category, and the bank does not plan to sell them.
Sell or wait?
Treasury yields and bond prices move in opposite directions. As yields rise, the prices of existing bonds fall, deepening the unrealized losses reflected in AOCI. "Given where rates have moved, it may be worth taking the loss and reallocating the money into higher-yielding assets, which would benefit future cash flow and capital generation," said Macrae Sykes, portfolio manager at Gabelli Funds.
The risks in bond portfolios are not merely hypothetical. In 2023, huge losses on bond investments combined with rapid customer deposit withdrawals helped bring down Silicon Valley Bank. Although US banks have since reduced their exposure, the recent surge in yields shows that decisions made years ago can continue to be a drag. "If higher yields on replacement assets can make up for that loss within a reasonable time frame, banks should be willing to take the loss," said Brian Jacobsen, chief economic strategist at Annex Wealth Management.
Buybacks could stall
This impact is already showing up in banks' plans to return capital to shareholders. Fifth Third Bancorp (NASDAQ: FITB) said it postponed a share buyback originally scheduled for September after the sharp rise in rates affected its AOCI. Wells Fargo & Co (NYSE: WFC) also said future buybacks may depend in part on how rates affect its investments. "Looking ahead, we will continue to consider the rate environment and the impact on accumulated other comprehensive income when deciding how many shares to repurchase," Wells Fargo Chief Financial Officer Mike Santomassimo said in remarks to analysts.
Meanwhile, Truist Financial Corp (NYSE: TFC) has been repositioning its securities portfolio. Chief Financial Officer Mike Maguire said the bank believes there is room for further sales, but the pool of bonds it can act on is limited. "As Basel III truly comes into focus and is close at hand, we do feel it is prudent to take action on the securities portfolio." Basel III is an international regulatory framework that could affect how banks manage their investments and how much capital they can return to shareholders. These rules could add another layer of complexity to banks' decisions on managing their bond portfolios. Executives at PNC Financial Services Group Inc (NYSE: PNC) also said the bank is factoring "soon-to-take-effect" Basel III capital rules into its assessment of its AOCI holdings.
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