Wells Fargo & Co (WFC), Bank of America Corp (BAC): How to Navigate the Bond Market

According to a recent report by the Federal Reserve, household debt in the U.S has declined to its 2006 levels. This drastic reduction was a direct impact of the Fed’s liquidity injections, which have resulted in a declining unemployment rate and rising consumer spending. This is great news for the banking industry, as debt repayments have lowered the risk of defaults and unlocked liquidity for reinvestment purposes.

Why Wells Fargo & Co (NYSE:WFC)?

One of the best ways to play this recovery is by investing in Wells Fargo & Co (NYSE:WFC). It is by far the largest mortgage originator in the U.S, with a 22% market share, and it originated $524 billion worth of home loans in FY12. However, the best thing about the bank is that it has over $160 billion in cash and cash-like instruments due to rapidly growing deposits.

Normally, idle cash and cash equivalents points towards a poor reinvestment mechanism in a company. This is because its ROE and ROI ratios are dampened by inaction. But in a recent press release, the management of Wells Fargo & Co (NYSE:WFC) announced that it is buying bonds at a relatively faster rate.

The above chart displays the trends of 10-year Treasury bonds. The benchmark 10-year Treasury yield started rising, shortly after the Fed announced that it might terminate the monthly QE3 stimulus sooner than expected. The market got spooked due to weak investors confidence, following which money started flowing out of bonds.

The bank stated that it has created a portfolio of certain instruments, which altogether profit the bank if interest rates start to rise. Theoretically speaking, if Wells Fargo & Co (NYSE:WFC) invests its entire liquid cash into 10-year bonds at the current yield of 2.52%, it will be looking at $3.84 billion in annual interest income. That will boost its annual net income by around 20%, which is why Wells Fargo & Co (NYSE:WFC) presents a bullish case.

But that’s just theoretical, and the bullish bond market is feared to have come to an end.

Why Is the Street Worried?

Bank of America Corp (NYSE:BAC) is particularly bearish on the bond market and advised investors to close their positions in bonds, while they still have a chance. The bank stated that the termination of Fed’s easing will leave a gaping hole on the buying side, due to which bond yields can continue to soar. And since major banks will now start selling bonds, there’s a good chance that bond yield becomes volatile and trap long-term investors. As of now, Bank of America Corp (NYSE:BAC) has bearish bets on treasuries and stands to gain $1.6 billion if interest rates rise by 1%.