Do Bank Capital Notes Merit Investment Stature?

Abstract

IN THE MAY-JUNE 1966 issue of the Financial Analysts Journal, an article questioned the relatively low level of yields on capital notes of commercial banks in view of the risks seemingly inherent in this type of security.' This article stated that yields on better-known bank capital notes should not command yields approaching those of Aa-rated corporate obligations. In support of this position, reference was made to the low level of the time interest earned characteristic of bank capital notes. This ratio-which is two times or less for most banks-has traditionally been regarded as an important indicator of debt service ability for non-financial business corporations.2 The purpose of this article is to examine those quantitative factors which determine the ability of a bank to service interest and principal on its capital notes. It is contended that the cost structure of commercial banks makes the times interest earned multiple of limited significance as a measure of safety for bank capital notes. Instead, the ratio of pre-tax operating profits to gross operating income constitutes a better measure of debt service ability out of bank income. Also, the total funds flow of commercial banks, which includes changes in assets and liabilities, shows that commercial banks have substantial debt service ability not reflected in either times interest earned multiples or profit margin calculations. Much of the analysis in this article is based on data for all member banks so that conclusions will necessarily be general in character. The merits of the capital notes of a specific bank can be established only after analysis of that bank; its deposit structure, the economic characteristics of its service area, its competitive posture, management quality and depth and its past record and future prospects. Even so, this article suggests approaches for analysts to take in their evaluation of bank capital notes.