NEW YORK, Nov 14 (Reuters) - BlackRock Inc, a money manager that has long worked with the largest U.S. financial institutions, is now turning to the country's smaller banks, where it sees a promising market for exchange-traded corporate bond funds.
The roughly 7,000 regional and community banks across the country have securities portfolios totaling some $1.5 trillion, a majority of which are in mortgage-backed securities, according to BlackRock's own estimates.
That concentration might make them more vulnerable to interest rate risk. While all bonds get hurt when rates rise, mortgage bonds feel it more than other sectors, and regulators have been pressing banks to dial down their interest-rate risk by lightening up on these securities and investing elsewhere.
To BlackRock, that looks like opportunity.
"This is going to be a multiple-year trend and dialogue," said BlackRock managing director Jared Murphy, who is overseeing the effort to extend the ETFs.
Called iSharesBonds ETFs, the funds feature 100 to 200 investment-grade corporate bonds and a low-cost expense ratio of 0.1 percent. Each fund's underlying securities have a defined maturity designed to reduce interest rate risk. On a date certain, investors will know the bonds in the ETF are worth their full face value.
BlackRock won its first big convert last quarter when a west coast regional bank invested $100 million in one of the funds. Since the products launched in April, BlackRock has had conversations with more than 150 regional and community banks.
But some analysts said BlackRock could have a hard time selling the product. When smaller banks reduce their mortgage exposure, they are more inclined to buy Treasury securities, which essentially have no credit risk, instead of corporate bonds that can default.
"Community bankers feel like they're going to be the last in the food chain to know if there are any problems with a corporate issuer," said Edward Krei, managing director at the Baker Group, an Oklahoma City-based consulting firm that advises community banks.
To the extent that banks do take credit risk in their securities portfolios, it is generally confined to municipal bonds, Krei said.
The smallest of the community banks, with $5 billion or less in assets, had less than 5 percent in the category that includes corporate securities at the end of the last quarter, according to U.S. financial data provider SNL Financial.
They had roughly 42 percent of their portfolios in residential mortgage-backed securities, and another half split between Treasuries and munis.
Guggenheim Investments has a similar lineup of fixed-maturity ETFs, called BulletShares, that are made up of high-yield corporate bonds. Each fund targets a different maturity date, much like the iSharesBonds suite. It has not visibly marketed the ETFs to small banks, and declined to comment on that for this story.
REGULATORS ASK FOR DIVESTMENT
Earlier this year, the Office of the Comptroller of the Currency warned that increased holdings of mortgage-backed securities by banks with less than $10 billion in assets, "may make some institutions more vulnerable to interest-rate risk."
Regulators also require banks to assess the credit quality of the securities they hold, so BlackRock turned to its risk analytics division to provide credit monitoring.
"This is particularly important in the bank channel," said Chicago-based Morningstar analyst Ben Johnson, adding that, by including analytics, Blackrock increases its chances with small banks.
Big banks already have the resources to hire in-house teams to do credit quality research on securities, and BlackRock might have a leg up on later competitors because it is getting there first with robust credit analytics, Johnson said.
But the ETFs do not absolve bankers of all their responsibilities and headaches. The accounting treatment that banks usually choose for securities investments means that changes in the value of assets affect the balance sheet, even if they do not affect earnings.
BlackRock is "making it easy" for small banks to get corporate debt, but that might not be enough to win big business, suggests Jim Reber, president of Memphis-based ICBA Securities, a subsidiary of the Independent Community Bankers of America that sells securities to member banks.
"If (a bank) doesn't want to have exposure, there's no amount of ease of entrance into that market that is going to change their mind," he said.
Murphy remains undeterred. With total assets in the funds at just north of $350 million, he hopes to grow the business to $500 million by year-end. This includes sales to other clients and bigger banks that might simply use the ETFs for easy and inexpensive corporate exposure. He aims to make it a multi-billion-dollar business over the next few years.
The bank client segment right now is just a small slice of BlackRock's larger iShares business, which it acquired from Barclays in 2009. The iShares unit, the largest U.S. ETF business, accounts for roughly 30 percent of BlackRock's total revenue.