BTO: U.S. Financial Sector CEF Ideal For Investing Over The Long Run (NYSE:BTO)

Khanchit Khirisutchalual

John Hancock Financial Opportunities Fund (NYSE:BTO) is a closed-end equity mutual fund (“CEF”) that invests in equity shares of U.S.-based financial companies, mostly in banks. BTO’s Portfolio consists of regional banks, and generates strong yields. During the past 10 years, it has generated an average yield around 5.5%, which probably will come down due to the current macroeconomic situation. This fund uses leverage, but that’s not a significant component.

John Hancock Financial Opportunities Fund is suitable for investors who want to bet on financial companies’ equities, as BTO has been successful in outperforming the Financial Select Sector SPDR Fund ETF (XLF) over the past 10 years. The fund has registered a total return of 25%, and 202% over the past 3 years and 10 years, respectively. However, BTO may have to face the problem of low margin in the short run. This makes BTO an interesting fund to watch in order to accumulate this stock at the right price.

BTO’s Portfolio Consists of Regional Banks, and Generates Strong Yields

John Hancock Financial Opportunities Fund was launched and is managed by John Hancock Investment Management LLC. The fund is co-managed by John Hancock Asset Management. BTO benchmarks itself with the S&P Composite 1500 Banks Index (SP1500-4010). BTO is fairly granular, with only M&T Bank Corporation (MTB) constituting more than 2% of the entire portfolio. Most of the top 18 holdings, in which BTO has invested more than 1.5% of its entire fund, are composed of U.S.-based regional banks, instead of globally known banking giants like Citibank (C), JPMorgan Chase (JPM), Wells Fargo (WFC), U.S. Bancorp (USB), Truist Financial Corp (TFC), Goldman Sachs (GS), Capital One Financial (COF), The Bank of New York Mellon Corporation (BK), TD Group US Holdings, or State Street (STT).

Rather, John Hancock Financial Opportunities Fund has invested significantly in the stocks of smaller banks and investment management firms, such as MTB, Huntington Bancshares Incorporation (HBAN), Zions Bancorporation, National Association (ZION), Ares Management Corporation (ARES), Citizens Financial Group, Inc. (CFG), Fifth Third Bancorp (FITB), Regions Financial Corporation (RF), Blackstone Inc. (BX), KKR & Co. Inc. (KKR), Ameris Bancorp (ABCB), Cullen/Frost Bankers, Inc. (CFR), Comerica Incorporated (CMA), WSFS Financial Corporation (WSFS), KeyCorp (KEY), Premier Financial Corp. (PFC), Hancock Whitney Corporation (HWC), Popular, Inc. (BPOP), etc. The fund has invested almost 30% in these companies. Interestingly, none of these companies are insurers.

John Hancock Financial Opportunities Fund was formed on August 23, 1994 as John Hancock Bank and Thrift Opportunity Fund. It initially paid annual dividends, but moved to quarterly payout in 2004. During the past 10 years, its average yield has mostly ranged between 5 to 6 percent. This yield however, most likely will come down due to current macroeconomic situations. We may not see an outright recession, but still the earnings will remain under pressure for another year or two. U.S.-based regional banks (in which BTO’s portfolio has huge exposure) have to raise interest rates rapidly to compete for deposits. At the same time, demands for fresh loans will be lower than before. In such an environment, net interest margin will be very narrow in the coming months.

Outlook of the U.S. Banking Sector

The primary risk faced by U.S. banks is that inflation may last longer than expected. The Federal Reserve is in the process of tightening its monetary policy through raising the benchmark policy rates and reducing asset purchases. These policies, though they will negatively impact demand and asset prices, are still unavoidable. The banking industry has already made provisions to cope up with these challenges. In addition, higher interest rates will be helpful in certain cases, as this may enhance the revenue spread for the banks. Over the long term, banks will have to pursue new sources of revenues beyond their existing products and tap into some new business models, and I believe that the U.S. banks are well-equipped to pursue that path.

According to a report published by Fitch Ratings on 28th June 2022:

“U.S. banks’ capital, liquidity and earnings have positioned them to weather what could be the beginning stages of stagflation, as the U.S. economy experiences inflation levels not seen since the early 1980s coupled with the potential for a sharp deceleration of real economic growth this year. Banks should be more resilient for a stressed macroenvironment, especially if short-lived, as capitalization levels are much stronger than during the stagflationary environments of the 1970s and early 1980s……Higher interest rates should theoretically benefit bank earnings, as net interest income should benefit from a rise in interest rates as bank assets typically reprice faster than liabilities.”

However, supply chain disruptions are not going to ease out in the near term, and will impact the economic growth to a large extent. Supply-chain bottlenecks that have spread throughout the globe, are going to determine how and where the businesses will finance their operations in the future. As this crisis makes less goods travel from one part of the world to another, the appetite for fresh loans slows down. It also makes the existing asset quality of a bank inferior.

Due to loan moratoriums and other government support, banks have been able to overcome this crisis over the past two years, but slowly those supports are phasing out. In my opinion, banks can hardly find any solution to this supply chain crisis. Due to this, I am cautiously optimistic about the banking sector.

Investment Thesis

Russia’s invasion of Ukraine, supply chain disruptions, record-high inflation, and tightening monetary policy are expected to make the U.S. economy fragile for another year or two. In addition, the ripple effects from slower growth among all the major economies worldwide will create additional pressure on the U.S. banking industry. A mild recession or stagflation cannot be ruled out. And this expectation of a probable recession may impact the financial sector in multiple ways. The coming months will be driven by a rise in deposit rates and lower demand for fresh loans. This will result in a gradual decline in liquidity and net interest rate margin. BTO, thus, may have to face the problem of lower margin and concurrent revenues of those banks in the short run.

But John Hancock Financial Opportunities Fund has been consistent in generating strong total returns over the long-term. Long-term investors can thus hold their positions in BTO, as the fundamentals remain strong. In my opinion, the well-capitalized, diversified regional banks should weather the storms reasonably well. For the regional banks, capital ratios will converge with pre-pandemic levels, and mergers and acquisition (M&A) activities will spurge, which again will generate more value for their equity shares. Thus, the US banks will probably be able to tackle the temporary pressure on interest rate margin. Short term investors may wait for this stock to fall further, as lower income will probably hurt the yield.

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