Regional banks had underperformed the bigger, better-known banks last year and in the early part of this year thanks to low interest rates which led to a narrowing spread between long- and short-term rates. This hurt the net interest margin earned by banks, which a key metric for the sector.

However, the end of the QE stimulus in the U.S. and steady economic growth of the U.S. economy (4.6% in Q2 and 3.9% in Q3) completely changed investors’ outlook toward regional banks. The investing world started to speculate the time of the short-term rate hike which was kept at rock-bottom levels (read: What is Driving Bank ETFs Lower?).

This situation drove rates higher. While this gave a push to the bank ETFs as banking stocks are expected to benefit from a rising rate scenario, a widely accepted view is that rising rates are followed by lenders’ rate hikes on loans faster than what is paid on deposits.

But, against popular belief, interest rates have fallen this year thanks to the risk-off trade sentiment prevailing in the market. A slow start to the all-important holiday shopping season with consumers reluctant to loosen their purse strings evident by the 11% drop in post-Thanksgiving spending prompted a defensive mood in the market. A continuous plunge in oil and gold prices should also add to the volatility in the investing world.  

All these incidents had an aftereffect on bond yields. The yield on 10-year Treasury note was 2.28%, down 53 bps year over year while the yield on 3-month Treasury note was 0.03%, down from 0.05% noted on the same day of the last year (read: Time to Sell Regional Bank ETFs?).  

If this situation continues for long, it may wreak havoc on banks as these seek to borrow money at short-term rates, and lends the capital at long-term rates. Though the current ultra-low rates have reduced borrowing costs for banks, a further drop in the lending rates which the banks receive, led to the shrinking interest rate spread and affected net margins and banks’ profits. Moreover, revenues from mortgage fees will likely lessen as the boom in mortgage refinancing fizzles out.

Due to this, investors should pay close attention to the following banking ETFs. These funds could face trouble if this trend continues, or if the spread finds a way to tighten even further from here:

PowerShares KBW Bank Fund (KBWB)

This fund tracks the KBW Bank Index, which measures the performance of the companies that do business as banks or thrifts and are publicly traded in the U.S. It has AUM of $275 million and sees moderate volume of more than 150,000 shares per day, ensuring little additional cost beyond the expense ratio of 0.35% (read: Will Cyber Attack Halt Rally in Financial ETFs?).

Banks take the top spot with 92% of portfolio. KBWB is a value style fund with focus on large caps, as these account for 71% of the assets. The ETF was up just 6.2%  while the fund has a Zacks ETF Rank of 3 (Hold) with a Medium risk outlook.
 

SPDR KBW Bank ETF (KBE)

The fund tracks the S&P Banks Select Industry Index, giving investors exposure to the U.S. banking space. The fund holds a basket of 61 stocks with the top three holdings – Susquehanna Bancshares, Radian Group and MGIC Investment Corp. – each receiving about 2% of the portfolio. 

Sector-wise, regional banks occupy around 72% of fund assets, followed by thrifts and mortage finance (about 12.1%) and Diversified Banks (10.42%) (see all Financial ETFs here). 

The fund has been a flat for the most part this year though it is currently sporting a loss in the 1.7% range so far this year. The fund charges about 35 bps in fees a year, though the ETF currently carries a Zacks ETF Rank #2 (Buy) with a High outlook.

SPDR S&P Regional Banking ETF (KRE)
 
This is one of the largest and the most popular ETF in the banking space with an AUM of nearly $2.1 billion and average daily volume of roughly 3.6 million shares. The product follows the S&P Regional Banks Select Industry Index, charging investors 35 basis points a year in fees. The product holds a well-diversified basket of 83 stocks. It uses an equal-weighted strategy and hence minimizes concentration risk.

None of the individual stocks form more than 1.88% of total fund assets. The fund has lost 2.1% in the year-to-date frame (see all the Top Ranked ETFs here).

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