A Pairs Trade With Two Bank ETFs (KBE, RKH)

Includes: KBE, RKH
by: Michael Panzner

Recent speculation that the Federal Reserve Bank may be nearing the end of its monetary tightening cycle -- the so-called "one-and-done" perspective -- has helped spur renewed optimism about prospects for the banking sector.

For smaller institutions, however, there are signs that credit quality has been deteriorating in recent years. That may undermine any hopes for further improvement in their fortunes -- and share prices -- if rates do, in fact, stop moving higher.

More specifically, while larger institutions have seen net nonperforming loans and charge-offs as a percentage of loans outstanding holding steady or falling relative to the overall universe of U.S. insured banks, similar measures for institutions with assets below $20 billion have been moving in the opposite direction, as the accompanying graph shows.

Given that, we may be looking at a two-tier market, with larger banks outperforming their smaller brethren in the period ahead. Longer-term, however, deteriorating credit quality at the smaller banks may prove to be the canary in the coal mine for the sector as a whole.

One possible pairs trade: buy the streetTRACKS KBW Bank ETF (NYSEARCA:KBE), and short the Regional Bank HOLDRS (NYSEARCA:RKH).

Click image to enlarge: