Bond Portfolio Losses At Bank Of America Are The Highest Among Peers

One of the country's largest banks, Bank of America BAC +1.81%, is sitting on the most significant losses among the nation's biggest banks, namely in a key segment of its bond portfolio.

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Bank of America (ticker: BAC) is another bank that invests in Treasury securities and mortgage-backed securities in addition to making loans to its customers. The value of the bond portfolios held by banks has been declining in recent years as interest rates have risen since the start of 2022, resulting in a decline in their value. When interest rates rise, bond prices tend to fall as well.

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Approximately $3 trillion worth of debt securities were held by Bank of America on its balance sheet at the end of 2022, representing a total value of $862 billion. It is estimated that $632 billion in bonds were held to maturity for accounting purposes, most of which were mortgage securities issued by federal agencies.

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The banks do not have to record losses on changes in the value of those securities, which would eat up their capital unless the debt is sold by the banks. While holdings in that bucket, which carry a minimal to no credit risk, showed a loss of about $109 billion at the end of 2022 due to the rise in interest rates over the past year, despite holdings in this bucket being low-risk or carrying no credit risk.

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In contrast, JPMorgan Chase JPM +1.40% (JPM) suffered losses of $36 billion for a similar-looking bond portfolio, Wells Fargo (WFC) suffered losses of $41 billion, Citigroup C +6.81% (C) suffered losses of $25 billion, and Goldman Sachs Group GS +2.82% (GS) suffered losses of just $1 billion, according to the 10-K filings filed with the Securities and Exchange Commission by each of the companies.

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It has been reported that banks' bond losses have increased since regulators seized Silicon Valley Bank on Friday. There was a $15 billion unrealized loss on the $91 billion portfolio of held-to-maturity bonds owned by SVB Financial SIVB 0.00% which is the parent company of the lender. Almost all of its tangible capital of $16 billion was equivalent to that amount of money. 

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Additionally, banks also classify their holdings of debt and other securities under a different accounting treatment known as available-for-sale. Any loss on these securities must be reflected in capital levels, and the capital must be reduced even if the debt is not sold as a result. This accounting treatment was applied to $221 billion of bonds of Bank of America, and at the end of 2022, that bucket of bonds showed a loss of about $4 billion due to this accounting treatment.

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After getting hit last week, bank stocks fell again on Monday. Despite trading under $28 early in the session, Bank of America fell 3.8% to $29.13 late in the afternoon. The stock price of JPMorgan Chase dropped 1.2% to $132 and that of Wells Fargo (WFC) dropped 5% to $39.29.

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This accounting rule allows banks to invest in Treasury and federal agency mortgage securities that carry minimal or no credit risk in the long run for the purpose of holding them until the maturity of the bonds, which is the purpose of the held-to-maturity accounting rule. Depending on whether or not that happens, the losses resulting from changes in the bond prices will melt away as the bonds mature, and the principal will be repaid in full as the bonds mature.

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In the same way that other big banks have a great deal of liquidity at the moment, Bank of America does not face any pressure to sell any of its holdings of held-to-maturity bonds and realize losses as a consequence.

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In 2022, Bank of America had $1.9 trillion in deposits, which included about $1.4 trillion of retail deposits, which are usually kept at one bank due to the time and effort required to move them from one bank to another. As part of the Federal Reserve's efforts, the Fed also provides a backstop to banks in the form of loans if they are in need.

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But the size of a bank's bond portfolio along with the losses suffered as a result is indicative of the interest-rate risk that lenders are exposed to, or what is known as the duration risk. This is one of the main reasons why Bank of America stands out among its competitors in that regard.

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No comment was provided by the company.

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“The big question for investors and depositors is: how much duration risk did each bank take in its investment portfolio during the deposit surge, and how much was invested at the low yields on Treasury and Agency bonds?” wrote Michael Cembalist, the chairman of market and investment strategy at J.P. Morgan Asset & Wealth Management.

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Cembalist measured the theoretical hit to bank capital, in terms of a measure called Common Equity Tier One capital, that lenders would face from "an assumed immediate realization of unrealized securities losses," with SVB coming out on top with by far the biggest effect on bank capital. The biggest impact of the crisis was seen at Bank of America, which is the world's largest bank.

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When held-to-maturity bonds are sold, any losses must be realized and depress capital. Compared with $175 billion of year-end tangible common equity, Bank of America's held-to-maturity bond portfolio has unrealized losses of $109 billion.

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2% is the yield on the bank's $632 billion of held-to-maturity bonds. Most of them, approximately $500 billion, are agency mortgage securities maturing in 10 years or more. 

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Wells Fargo analyst, Mike Mayo, has stated that putting a lot of attention on Bank of America's mark-to-market losses on its bond portfolio ignores the importance of the deposit base that underpins the holdings that are so important to the bank.

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"The underlying gains on the deposits offset the losses" that may have occurred on the bond portfolio, according to him. There is a nuance to this approach since banks don't care about their deposit franchise when it comes to value it. In Mayo's opinion, the deposit base of Bank of America, upon which the bank is paying 1% or less for the bulk of its retail accounts, is of enormous value and would be extremely difficult, if not impossible, to replicate if this was the case. As interest rates rise and the spread between what banks pay for deposits and the interest they receive on loans widens, the value of low-cost deposits goes up, as low-cost deposits become more valuable.

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Mayo considers the federal agency debt and Treasuries held by the bank to be money-good securities, so there is no reason for them to be sold.

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Although one might question the wisdom of Bank of America having large investments in longer-dated mortgage securities at historically low yields, one does have to question its investment strategy. There has been a rally in the bond market in recent days, but mortgage bond yields are closer to 5% than 4.5% at the moment. 

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There could be a potential contraction of the bank's net interest margins if the bank has to pay a higher rate for a deposit given the wide spread between the market rate on money-market funds and the rate on high-yielding bank deposits if it needs to pay an appreciable more for a deposit.

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The effective maturities of mortgage securities, usually expressed as an average life, are usually lower than the stated maturities of the securities. Generally, these loans mature before the stated maturity dates, often within 30 years as a result of customers paying off their debt when they sell their houses to move or refinance them. 

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There is one unfortunate aspect of mortgage securities for investors, which is that the life expectancy of these securities increases as rates rise, something known in the bond market as negative convexity. There is some logic to this since rising interest rates give people less reason to repay their low-cost borrowings or refinance their properties.

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Neither the effective maturity nor the average maturity of Bank of America's bond portfolios is disclosed.