Portfolio Strategy

May 29, 2020

The Long and Short

Community bank paper offers attractive returns as market rallies

Dan Bruzzo, CFA | May 29, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

With the market continuing to rally, investors should seek out additional spread compensation available in smaller regional and community bank paper, which offer attractive yields relative to the tighter spreads available in large IG regional bank paper. Smaller bank paper with significant opportunities to outperform more liquid issues from the regional bank segment include issues from Texas Capital Bank and New York Community Bancorp.

Two weeks ago we highlighted that Banking has maintained its position among the  top performing sectors within the entire IG Index throughout the recent market selloff and recovery (APS Strategy: Bank Stock Selloff).  Since the early weeks of the COVID-19 crisis we have been stressing an Overweight on Domestic Bank credit with an emphasis on the big US money center banks (APS Strategy: adopt-defensive-posture).

Opportunity 1: Texas Capital Bank NA (TCBI)

  • TCBI 5.25%  1/31/26 @ $108.25; CUSIP 88224PJS9
  • G+321, 3.63%
  • Amount outstanding: $175 million (non-index)

Senior HoldCo Rating: Baa3/BB+/EJR: BB+

Subordinated Bank Issue: Baa3/BB+/EJR: BB-

Bullet structure

Closest operating peers: UCBI, BKU, IBTX, HWC, BOKF

Exhibit 1. TCBI 26s attractive relative to IG bank bullets

Source: Amherst Pierpont Securities, Bloomberg/TRACE Indications

Texas Capital Bancshares (TCBI) has been in the headlines the past week after its recently announced merger with Independent Bank Group (IBTX) was called off, citing concerns about the COVID-19 crisis, and the ability of the banks to successfully merge under the economic conditions. The deal had been structured as an all-stock transaction, limiting the immediate term credit implications for TCBI. Still, the deal carried enough execution risk that Moody’s came out this week stating that the merger termination is in fact a credit positive for TCBI, but with no immediate ratings impact. The merger with IBTX would have added nearly $16 billion in assets to TCBI’s existing $35.9 billion in assets, $27 billion in deposits and $25 billion in Total Loans. The bank has seen rapid growth in recent years, expanding from $22 billion in total assets as recently as 2016. However, TCBI has done so since the Financial Crisis largely through organic expansion rather than through acquisitions. IBTX would also have increased its branch presence, which only stands at 12 locations spread through its home state of Texas.

TCBI is largely a commercial lender, with C&I representing 32% of total loans, with a combined 22% from Commercial Real Estate (CRE) and Construction. Energy and Leveraged Lending exposure have drawn scrutiny as notable risks in the bank’s loan mix, but both have been reduced to less than 5% of total loans, and the bank carries significant reserves for its energy loan book. While this energy exposure is higher among regional banks, we view this as a known and manageable risk for which investors are well compensated. The remainder of the loan book is largely comprised of warehouse lending. Credit quality is currently high in the loan book with Non-performing Assets (NPA) representing only 0.61% of total assets as of 1Q20. That ratio only reached a peak of 0.95% during the last energy crisis (’15-16) and peaked at less than 2.5% at the height of the Financial Crisis.

The bank has adequate capital with a Tier 1 (CET1) ratio of 9.27% as of 1Q20, and a total Tier 1 Risk-Based Ratio of 10.16%. The loan/deposit ratio is 92.95%, suggesting sufficient funding for its entire loan book through traditional deposits. Reliance on wholesale funding is less than 20% of liabilities, with very little reliance on short-term money markets. Brokered deposits were less than 15% of the total as of year-end 2019.

Opportunity 2: New York Community Bancorp Inc. (NYCB)

  • NYCB 5.9% 11/06/28-23 @ $98.75; CUSIP 649445AC7
  • 6.31% YTC (11/23)
  • 4.83% YTM (11/28)
  • Amount outstanding: $300 million (index eligible)

Senior HoldCo Ratings: Baa2/BB/BBB-

Subordinated Issue: Baa2/BB/BBB- (Although technically the most senior in cap structure since all other outstanding public debt issues are TruPS)

Callable 11/06/23; Float 3ML+278

Closest operating peers: SBNY, DCOM, OPB, STL, FFIC

Exhibit 2. Recent Community Bank Issuance – 10NC5 structure

Source: Bloomberg/TRACE price indications, Amherst Pierpont Securities

NYCB was among the top performers in the IG Index in 2019. Obviously, it was hit hard in the sell-off, but we see very good value in current risk compensation considering the bank has over $50 billion in assets and the deal is index-eligible. NYCB should trade closer in-line with large, IG-rated regional comps, such as SOV, CFG, SNV, PBCT, BKU, etc on a yield basis. Although the callable structure is akin to the USD private bank market that is mostly dominated by smaller regional and community banks, the NYCB deal maintains two IG ratings and $300 million outstanding, placing it closer to the IG-rated universe of large BBB regional banks (see below). NYCB’s closest peer Signature Bank NY (SBNY: Subordinated Ratings: Fitch – BBB, Kroll – A) came market with a non-index 10NC5 sub note at 4.125% coupon in late October; those bonds are now yielding ~4.175% to call.

Exhibit 3. Intermediate BBB Regional Bank Paper: Yield vs Duration – contains bullet and callable structures

Source: Amherst Pierpont Securities, Bloomberg/TRACE Indications

NYCB is a Long Island based bank with roughly $54.3 billion in total assets, $32.0 billion in total deposits and $42.3 billion in total loans as of 1Q20. The bank is among the leaders in New York City area apartment lending; and the largest among similar local competitors, such as Signature Bank (SBNY), Dime Community (DCOM), Flushing Financial Corp (FFIC) and Sterling Bancorp (STL). The bank operates out of 238 branches in 5 states. The bulk of operations are under the New York Community Bank nameplate; for the remainder, they have retained the identity of several other community bank operating companies they have added over the years (NY Commercial Bank/Atlantic Bank, Roslyn, Queens County, Garden State Community, etc).

The bank’s concentration in multi-family lending is high at roughly 74.2% as of 2Q19. That compares with ~42% in apartment lending for SBNY, ~70% for DCOM, ~41% for FFIC, and ~23% for STL. The remainder of NYCB’s loan book is mostly in Commercial Real Estate (CRE – about 17%) and Commercial & Industrial (C&I – about 5%) lending. The bank has grown from just under $2 billion in assets 20 years ago; although though unlike many peers, most of the growth was experienced before the financial crisis. The bank’s expansion was a balanced mix of organic and select M&A activity in the earlier 2000s. Obviously, concentration in apartment lending in the NYC area creates some degree of longer-term concerns with regards to COVID-19 and the prospect for permanent or lasting changes to desirability of city living. S&P assigned a negative outlook to the rating along with 12 other peers on May 4, 2020. Fitch followed suit last week. The state-wide moratorium on evictions was recently extended to August 20 from June of this year. Within its C&I lending are the taxi medallion loans, a hard hit segment of niche lending in recent years. However, this now represents less than $70 million to NYCB, and is a negligible credit factor.

NYCB will undoubtedly see a temporary rise in credit costs and delinquent loans over the next several quarters; however, the bank’s strong presences and conservative lending practices in a premium market are evident in the current lack of credit issues within their loan book. As of 1Q20, non-performing assets (NPAs) made up a negligible portion of total assets (0.11%), for which they were reserved at over 270%. For a little context on the COVID-19 crisis, at the peak of the Financial Crisis NYCB’s NPA rate never rose above 2% — an extremely impressive statistic among regional banks that speaks to the resilience of the NYC multi-family real estate market even in times of extreme stress. The bank’s Texas Ratio—which measures adj. NPAs plus 90-day past-due loans as a percentage of Common Equity and loan loss reserves—is remarkably only around 1.4%. The measure is a good indicator of all-in loan book risk versus liquid capital, and typically results anywhere below <20% are manageable (in most cases) for small-to-mid regional banks.

 NYCB is well capitalized with a Tier 1 Common (CET1) ratio of 9.81% as of 1Q20 and total risk-based capital ratio of 13.2%. The loan/deposit ratio for the bank is currently around 132%. NYCB’s reliance on wholesale funding is high versus peers, particularly its use of short-term money markets. The loan book is currently around ~46% wholesale funded, which is roughly double the level of typical similar size/positioned community banks. This is a known risk for which investors are well-compensated. NYCB is very comfortable with this funding profile, and has a proven track record over the past twenty years of managing different yield environments. The current rate environment favors the bank since their exposure to money market funding makes NYCB liability sensitive – as rates remain under pressure, their funding costs will remain lower (and help mitigate losses to margins).

One of the more visible risks that has generated attention over the past year in NYC apartment lending is the New York rent control rules that passed last June. While the rules are “renter friendly,” we do not believe they are by any means disastrous to landlords. The Housing Stability and Tenant Protection Act of 2019 limits rent increases for the roughly ~1 mm in rent-controlled apartments in New York (state not city). The rules still allow for rent increases for major capital improvements, though standard improvements are now capped at 2% increases per year from 6%. Owner use carve-outs have also been limited, while tenant income will also factor in to rent stabilization. The biggest perceived impact is that the new rules could limit price increases, which in turn would limit property turnover, and in turn limit prepayment income from refinance activity. While there will undoubtedly be some moderate erosion of margins in the near-term and slower loan growth, those risks are manageable for both NYCB and SBNY and have been priced in to both debt and equity values over the past several months. Furthermore, these changes are unlikely to have any material, long-term impacts on vacancy rates and therefore loan credit quality.

Dan Bruzzo, CFA
1 (646) 776-7749
dbruzzo@apsec.com

This material is intended only for institutional investors and does not carry all of the independence and disclosure standards of retail debt research reports. In the preparation of this material, the author may have consulted or otherwise discussed the matters referenced herein with one or more of Amherst Pierpont’s trading desks, any of which may have accumulated or otherwise taken a position, long or short, in any of the financial instruments discussed in or related to this material. Further, Amherst Pierpont may act as a market maker or principal dealer, and may have proprietary interests that differ or conflict with the recipient hereof, in connection with any financial instrument discussed in or related to this material.

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