This bank stock is an excellent hedge against rising interest rates

Western Alliance Bancorporation (WAL -3.48%) describes itself as “the bank for all seasons” for having the flexibility to quickly adapt its business and capital allocation in response to changing market environments.

The bank has demonstrated its ability to adapt and maintain strong results in a horrific market during the pandemic. And even though Western Alliance’s share price fell along with the rest of the market in 2020, the company’s management quickly adapted its business. For example, by the end of 2020, Western Alliance’s net income had grown rapidly and the stock had recouped all of its March losses.

Today, the economic situation has changed and the bank must react to a rising interest rate environment. Here’s why Western Alliance is making a great investment in today’s market.

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1. Banks are interest rate sensitive

Typically, when the market thinks interest rates will rise, it looks for investments that will react favorably. And virtually all banks are interest rate sensitive, which means profitability can rise or fall depending on whether interest rates rise or fall.

Western Alliance, like most banks, typically uses the money customers deposit in the bank to make loans to people who need to borrow money. When a bank lends money, its profits come from the difference between the interest rates borrowers pay and the interest the bank pays depositors. As a result, a bank benefits from rising interest rates when it can increase the interest rate borrowers pay on their loans faster than it increases the interest paid to depositors, resulting in an increase profitability.

Western Alliance’s competitive advantage is that it can create higher margins than many other banks by maintaining a relatively large amount of non-interest bearing deposits – typically checking accounts. In the first quarter of 2022, Western Alliance paid no interest on 45.1% of its deposits. By comparison, Factset reported that in 2019, median large bank holding companies held 22.7% of total deposits in accounts that pay no interest, making Western Alliance lending costs lower than peer banks. Additionally, with a lower cost of funding loans, Western Alliance’s profitability grows faster than most banks when it raises borrower interest rates, meaning it is more sensitive to rate fluctuations. interest rate than many other banks.

2. Judicious use of variable rate loans

Banks that earn the most in a rising interest rate environment have a relatively high percentage of their loans in variable interest rate loans. These loans have rates that track increases or decreases in an interest rate or benchmark.

Western Alliance holds approximately 57% of its commercial loans in variable interest rate loans. Additionally, Western Alliance has protected itself from the downside of variable-rate loans during the pandemic by creating rate floors, or written terms in a loan agreement that ensure the interest borrowers pay will never fall below a specific rate – thus ensuring that a loan will remain profitable if interest rates fall below the floor.

The June 15 Federal Reserve meeting is expected to result in 84% of Western Alliance lending with a rate above the floor – meaning future rate hikes after June 15 will lead to higher net interest income (NII ), the banking version of a gross profit figure.

Western Alliance has projected that with an interest rate hike of 100 basis points (bps), or 1%, over 12 months from the end of March, its NII could rise from 6.8% to over 25 %. And with a 200 basis point 12-month rise, its NII could rise from 15.4% to over 40%. Thus, a rapid rise in interest rates should make Western Alliance shine.

However, one thing that could throw a wrench in the projections above is a recession – a scenario that would likely halt further interest rate hikes. Nonetheless, Western Alliance has a savvy management team that adjusts its business to do well if interest rates remain at historically low levels or if interest rates rise faster than expected, which means it there is a minimum drop if the rates do not rise.

The bottom line

While profitability in the form of net interest margin (NIM) remained relatively stable in the first quarter of 2022 at 3.32%, Western Alliance investors are betting on NIM’s expansion over the next year. And with solid loan growth expected to continue, analysts expect quarterly earnings to grow double-digit year-over-year in the second half of 2022.

Western Alliance has a current valuation of 8.27 times trailing earnings, compared to the regional banking sector average selling at 13.62 times trailing earnings – so the stock could be considered undervalued.

If you think interest rates will continue to rise, Western Alliance is a conservative way to invest in the trend.

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