The Long and Short
Relative value in KeyCorp holdco paper
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. This material does not constitute research.
KeyCorp (KEY: Baa1/BBB+/A-) has been among the bank names caught in secondary corporate bond market volatility over the past several sessions, but selling in the name appears overdone. This appears particularly true for the holding company obligations relative to the bank notes, making the holding company paper the better relative value.
The most accurate peer group for KEY in terms of both size, ratings and risk composition would be the larger regional banks that fall into the $100 billion to $250 billion asset range. Among those banks would be operators that include Fifth Third (FITB: Baa1/BBB+/A-) with $209 billion in total assets, M&T Bank Corporation (MTB: A3/BBBB+/A) with $203 billion in total assets and Huntington Bancshares (HBAN: Baa1/BBB+/A-) with $189 billion in total assets. Senior holding company intermediate notes issued by this peer group are trading with more day-to-day stability in recent sessions and with valuations that skew closer to high $80s to low $90s.
In recent trading, KEY has traded in the context of banks such as Comerica Inc. (CMA), Zions Bancorp (ZION), First Horizon (FHN) and others in experiencing sensitivity to day-to-day shifts in market sentiment, despite being over twice the size of these counterparts. Pricing in KEY’s senior and subordinated debt obligations took a sharp leg down beginning May 3 along with the broader segment. KEY debt instruments have been settling in the low-to-mid $80s range throughout the past week, though not entirely trading on a dollar-price basis just yet. While valuations on most banks below the very largest have been affected by this banking crisis, valuations seem low in part because KEY holding company assets dominate holding company liabilities. (For more on this topic, please see the discussion on regional bank capital structures published last week.)
Applying the lessons learned from recent bank resolutions and given weaker pricing relative to peer holding company notes, KEY holding company debt obligations appear to offer the more attractive valuation with significant support from the asset side of the balance sheet (Exhibit 1).
Exhibit 1: KEY holding company debt looks like the better relative value
Source: Santander US Capital Markets, Bloomberg/TRACE indications only
Based in Ohio, KEY boasts a very stable, operating footprint with nearly 1,000 branch locations in 15 states across the Midwest, Northeast and Northwest US. The bank has total assets of $197.5 billion and current deposits of $144.15 billion as of first quarter 2023, placing it among the top 15 banking institutions in the US. Size does not make a bank immune to difficulties, of course, as Silicon Valley Bank stood at just under $212 billion in assets at year-end prior to collapse, while FRC reported $233 billion in assets just prior to being placed into receivership. But other factors complicated the balance sheet of those banks.
KEY had its Baa1 senior rating affirmed and outlook revised to Negative from Stable by Moody’s on April 21, when the agency made about a dozen or so rating actions on the banking sector, which included about 10 actual downgrades. In addition to the general deterioration in the operating environment and funding conditions for banks, Moody’s cited several specific risks related to KEY. The rating agency pointed out that the bank’s uninsured deposits were over 50%, which is somewhat high for the sector, but also noted that roughly 70% of deposits are stable, retail, collateralized or low-cost escrow, which offsets a lot of those concerns. At the time, using year-end calculations, Moody’s also estimated that total unrealized losses in the securities portfolio were equal to over 50% of tangible common equity, and those unrealized losses plus 15% of residential mortgages was nearly 80%.
Impressively, KEY saw very little, if any, deposit erosion in the first quarter of the year. Period-end deposits actually increased 1% sequentially to $144.15 billion in the first quarter of 2023, while average deposits declined only 1.6% to $143.41 billion. That stability stands in comparison to 2% to 5% drops in deposit balances at similarly positioned banks. While over 50% of the deposits are uninsured, KEY’s average deposit size is a very modest $34,228 as of the first quarter of this year, reflecting its core retail deposit base. As of first quarter, peer FITB also has 52% of deposits classified as uninsured with a comparable average deposit size of $28,299..
Turning focus to the securities portfolio, according to the first quarter call report, the unrealized loss in the held-to-maturity (HTM) portfolio for KEY was $476 million, while the unrealized loss in the available-for-sale (AFS) portfolio was $5.68 billion for a combined $6.16 billion. That represents about 42% of KEY’s CET1 capital but just 3% of total assets. Once again using the comparison of peer FITB, the bank’s roughly $5.24 billion in unrealized securities losses as of first quarter are in a similar context, representing about 33% of CET1 capital and 2.5% of total assets.
Last week’s discussion on regional bank capital structures illustrated the confusing aspects of how the banks have been resolved so far in this banking crisis, as well as the unknown for banking institutions that may be resolved in the future. KEY employs a holding company/bank operating company structure. As such, investors can identify the available assets and liabilities at the holding company. As of year-end 2022, KEY had just under $3.8 billion in holding company debt outstanding. According to bond list above, that number currently stands at $4.15 billion. The grid below breaks out the holding company assets versus liabilities using the most recent data available, which is from year-end. The expected recovery value on total holding company liabilities was at 92% at the time. Technically, if we increase the holding company debt burden to the current level of $4.15 billion, keeping all else the same, that number would be closer to 85%. The bank also has $2.66 billion in preferreds outstanding, also at the holding company level.
Exhibit 2. KeyCorp and Fifth Third holding company data
Source: CreditSights, KEY Call Report, S&P Capital IQ Pro, Y-9LPs, year-end 2022 data
Commercial real estate (CRE) exposure has arisen as an area of concern for the banking industry given large concentrations of lending to potentially vulnerable elements of the domestic economy. As a large regional consumer and commercial bank, KEY has moderate CRE exposure, though seems well diversified in its loan exposure, and relatively insulated from some of the more vulnerable subgroups of the CRE segment. Total non-owner occupied CRE makes up about 13% of the bank’s total loan book, with a small additional exposure in construction and development loans. When they reported first quarter results on April 20, management provided enhanced disclosures on the CRE loan book. The largest exposure of CRE loans is in the lower-risk subgroup of multifamily at 7% of total loans. Meanwhile, higher risk areas, such as retail (1%), office (<1%) and lodging (<1%) made up much smaller portions of the bank’s total exposure. Within the very modest $950 million in office loan exposure, the largest segment is built-to-suit at 39%, while about 30% is defined as suburban and the remainder is tied to central business districts.
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