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Fed Officials are talking up short-term rates.

Recent comments suggest rates rising from 1% end of 2015 to 4% in 2016.

Custodian Banks will benefit from increased rates: STT Top Pick along with BK and NTRS.

The Fed has been talking up rates of late beginning with Yellen's comments about Funds at 1.0% by end of 2015 followed by Plossers forecast of 4.0% funds by end 2016. By that forecast, 2015 is shaping up to be a busy year for the Fed's monetary levers at the pace of 1/4% at every meeting.

If the recent Fed chatter materializes, it surely will provide headwinds for the overall stock market. Not to mention the strengthening dollar is sure to hit many international markets. We recently posted an article discussing the signs that reduced fed liquidity measures are impacting the market.

We have been examining several options for investors in a rising rate environment including bank loan ETFs, brokerage stocks, and now are looking at financials.

One particular financial business poised to gain is the asset custody or custodian bank business. These banks ensure the safekeeping of financial assets for investors as a third party from their asset managers. In its elemental form, mutual funds hold their investor's securities at a bank custodian. The use cases can become more complex where the banks may act as a trustee or may hold assets for broker dealers. Where this benefits the custodian bank is alongside the securities assets the clients' cash balances or equivalents, such as money market funds will be held in the custody account as well.

These cash balances provide custodian banks with revenue stream that grows as short-term rates increase. This occurs as banks will invest balances in short-term instruments capturing the float or spread to amounts paid to account holders. As short-term rates increase from nearly 0.00%, the earnings revenues will climb with little additional operating cost. Should the Fed's recent statements regarding short-term rates come to fruition, future years look very compelling with 2015 shaping up to be a banner year!

Custodian Bank Stocks

The three custodian banks poised to capture upside from rising rates are State Street (NYSE:STT), Bank of New York Mellon (NYSE:BK), and Northern Trust (NASDAQ:NTRS)

Our top pick in this sector is State Street for three reasons -- offering a compelling valuation, shareholder returns, and thoughtfully acquired businesses that will surely benefit its custody platform.

State Street has the lowest earnings multiple on a trailing and projected basis (see below). On a price to book basis, the stock is in line with both BK and NTRS. STT has maintained an attractive valuation while returning substantially more capital to shareholders.

We calculated the net payout to common shareholders combining common dividends with share repurchases. The difference between STT and the others is significant. As a percentage of market capitalization, STT's return exceeds 8%, while BK and NTRS are below three.

Finally, STT has made a significant push into the rapidly growing hedge fund space acquiring accounts from Goldman Sachs (NYSE:GS). The GS accounts are sure to add cash balances from which STT will realize the upside as interest rates rise.


As the interest rate headwinds increase, investors should look to custody banks as an attractive addition to their portfolios. Within the sector, STT is the most attractively valued.

Share Price70.2135.5865.31
Market Cap ($B)30.3140.3915.50
Bal Sheet Equity ($B)20.3837.527.91
Tangible Equity ($B)11.9815.007.37
FWD P/E12.3413.1316.70
Price to Tangible Equity2.532.692.10
Projected Dividend1.160.601.24
Projected Dividend Yield1.65%1.69%1.9%
Net Payout TTM ($B)2.560.910.46
Net Payout Yield8.43%2.25%2.94%

Source: Yahoo Finance

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.