Over the last couple of weeks, interest rates across the bond market have rising fairly drastically as a result of fears concerning tighter monetary policy. While at this time its not clear if the rise is justified, I have been looking for select companies that would benefit from rising rates. I’ve come across many financial names as you would imagine. In this article I would like to take look at Wells Fargo & Co (NYSE:WFC) in particular.
The mortgage king
Wells Fargo & Co (NYSE:WFC), a diversified financial company, has performed especially well so far this year in line with the broader sector. Share have moved higher by over 20% with much of this move coming in recent days. While the market has been especially turbulent this month, shares of the company has remained quiet and seemingly unphased by the speculation surrounding the future of quantitative easing.
Why?
Well, the company can drive higher profits over the longer term with higher interest rates. It is largest mortgage banking company in the country, with 26% of its revenues originating from this business segment. As I’m sure many of you are aware, mortgage rates have been in a steady decline for the last couple of years before bottoming out at just under 3.5%.
As ten-year treasury rates spike above 2.5%, longer-dated interest rates followed along. The 30-year mortgage rate spiked above 4% earlier this month and now sits at 3.93%. Wells Fargo & Co (NYSE:WFC) benefits from rising mortgage rates in two ways.
The first is that financial institutions generally watch their net interest margin rise as interest rise over the long term. Let me define net interest margin as the average yield on earning assets minus the average interest rate paid for deposits. The spread between the cost of borrowed money and the actual rates banks can charge their customers widens as interest rates rise.
Wells Fargo & Co (NYSE:WFC) generates 49% of its income from interest-generating loans. Over last couple of years, as seen above, the company has watched its net interest margins decline with interest rates. As mortgage rates rise, amid stable borrowing costs, the company should see its net interest margins rise once again. The revenue it generates from its mortgage business should contribute greatly to the top line as mortgage demand has risen alongside rising rates. The housing recovery, in combination with rising credit, is opening the doors to higher lending volumes.
Second, as interest rates rise, the percentage of mortgages paid off early actually declines. Odd, right? You would think that people would be more inclined to pay off their loans early when they are paying more in interest, but the opposite is actually true because discretionary income declines as rates rise. This allows Wells Fargo & Co (NYSE:WFC) to generate more revenues per existing loans.
Secondary plays
While Wells Fargo & Co (NYSE:WFC) is my top financial sector pick, other well-known financial institutions also look promising in a rising-rate environment. Look towards credit card companies to benefit from rising rates and improving credit quality. Discover Financial Services (NYSE:DFS) and Citigroup Inc (NYSE:C) have both reported strong financial data as of late.
