Revisiting opportunities in community bank paper
admin | January 10, 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.
Amidst an onslaught of new issuance and tight spreads, a niche market that warrants continued focus is the higher-yielding bonds from a subset of domestic banks: the large community and smaller regional banks, with roughly $15 – 50 billion in total assets. The relative value proposition is two-fold: (i) the callable structures frequently utilized by these issuers offer additional yield over bullets on a yield-to-worst and yield-to-maturity basis; and (ii) investors able to invest in the mostly non-index and non-investment grade subgroup can capture an additional liquidity premium.
In July of 2019, callables issued by large community/smaller regional banks were mostly yielding 3.5-5.5% (see Callable bank structures present alternative to corporate bullets), while investors are now more likely to be compensated in the low 3%-to-high 4% range. On a duration weighted basis, investors are still getting +150-300 bp of yield per turn of duration, a staggering amount when compared to the 45-50 bp of yield per turn being offered by the broad IG Banking segment at year-end. Opportunity for outperformance among these private placement bank securities still exists (see Mining liquidity in private bank placements), and the sector could potentially see renewed liquidity as investors reassess portfolios ahead of seasonal bank issuance in the weeks ahead. Domestic bank earnings season begins with Citigroup (C), JP Morgan (JPM), and Wells Fargo reporting on Tuesday 1/14/19.
Actionable security in the segment: Bank OZK (OZK) 7/1/2026 callable notes;
Indicative offer level (dollar price): OZK 5.50% 7/1/26-21 at $103.125
- 3.30% yield-to-call (7/21); spread-to-Treasury of +170/2-year
- 5.55% yield-to-maturity (7/26); spread-to-Treasury of +386/5-year
Issuer: Bank OZK (no longer a holding company)
Structure: Callable 07/01/2021 at par; floating spread of 3-month LIBOR + 442.5 bp
Amount outstanding: $225 million, non-index eligible
Senior ratings: Kroll – A-
Subordinated HoldCo issue: Kroll – BBB+; EJR – A-
Operating comps: SFNC, HOMB, PNFP, UCBI, STL, SBNY, TOWN, BUSE, OPB
Exhibit 1: US community bank subs – callables vs regional/money center bullets
- OZK Bank, which previously dissolved its HoldCo/OpCo structure, is a relatively sizable southern community/regional bank, with a sprawling footprint across its home state of Arkansas, Georgia, North Carolina, Texas, and Florida. With roughly 250 branches, OZK employs a traditional “brick and mortar” approach to banking. This helps the bank maintain extraordinarily conservative lending practices, despite concentrations in what can typically be more speculative lending categories. One of the bank’s core competencies is in Commercial Real Estate (CRE), specifically in construction and land development loans. Most of the lending is done within its branch footprint, though many development properties lie outside in areas that include Alabama (two branches there), Tennessee, and some large exposures in western states (CA, AZ, and CO among others).
- The bank currently has total assets of around $23 billion (updated regulatory numbers for year-end 2019 should be available by the end of January), with over $17 billion in loans and over $18 billion in deposits. OZK saw its most rapid period of expansion beginning in 2014, as total assets doubled in size from $4.8 billion at year-end 2013 to $9.9 billion at year-end 2015; during which period OZK merged with Summit Bancorp (AR), Intervest Bancshares (NY/FL), Bancshares Inc. (TX) and Bank of the Carolinas over this period. Shortly thereafter, OZK bought Community & Southern for $800 million, which again doubled total assets by year-end 2016. Despite this period of rapid expansion, OZK was very quickly able to employ its conservative lending techniques to these newly acquired branches, in large part by making sizable investments in risk management.
- Like a large portion of the large community/small regional segment, OZK’s loan book is weighted substantially toward commercial lending, with CRE (25%) and construction (38%) making up just under 60% of its loan book. Consumer loans make up the next largest and fastest-growing segment at 14%, with an additional 6.0% in residential, 6.5% in multifamily, and the remainder in C&I and other niche loan categories.
- OZK padded capital ratios to compensate for growth, and reached their highest levels at year-end 2018 since their large expansion began in 2014. Tier 1 Common (CET1) ratio is 12.7%, with a total risk-based capital ratio of 14.4%. Those levels are down from 15.7% and 16.7%, respectively, as of year-end 2013, but the bank is 4x larger and there is much more certainty about regulatory capital needs now versus back then. The bank maintains enough deposits to fund its entire loan book, with a loan/deposit ratio of 93%, and only utilizes wholesale funding for about 8-13% of liabilities. Use of shorter-term and professional money market funding was at 17% at year-end 2018, and brokered deposits were around 11%, both of which appear commensurate with their operating profile.
- Credit quality has not been a concern for OZK throughout recent periods of expansion. Non-performing assets (NPA) are just 0.40% of total assets, and the bank maintains well over 100% of those totals in reserves to meet potential charge-offs. The Texas Ratio—which measures NPAs and 90-day past-due loans as a percentage of all reserves as well as equity—is remarkably low at under 3%. A bank like OZK would not be considered an immediate risk unless that measure got above 20%. The low Texas Ratio indicates the bank is very well positioned to address potential delinquent loans with minimal impact to the overall credit profile. This was demonstrated in 3Q18 when the bank took two large loan charge-offs, for a combined provision of $42 million for the quarter, which was a significant earnings event, and reflected in share price; but there was limited if any consequence to OZK credit quality. Construction and development loans do have a tendency to see heightened delinquencies during periods of market stress, or at least in the limited scope of the ’08 financial crisis. At the peak of post-crisis loan charge-offs in 2011, OZK saw NPAs top out at 7.9% and its Texas Ratio temporarily rose above 60%. Both credit metrics quickly recovered, and the bank has almost completely overhauled its lending practices and risk safeguards since then.
- The bank’s net interest margin (NIM) is very high for its peer group at 4.47% as of 1Q19, as the bank’s portfolio provides higher margins than community/regionals with higher concentrations in C&I and residential. OZK’s return on average equity (ROAE) last year was 11.6%, which was down modestly from prior years, but included the large one-time charge-offs in late 2018. OZK has demonstrated the capacity to operate with a run rate in the 14-15% range in more normal operating years. The bank’s efficiency ratio (operating expenses vs operating revenue) was 37% last year, which is among the best in the peer group, and even more impressive when considering the sizable integration and investments to risk management over the past several years.