Custody Banks Like State Street and BNY Mellon Are Quietly Near Record Highs. Here's What's Driving the Rally.

Banks have rallied during the past few months, lifting the KBW Nasdaq Bank Index, which tracks the largest U.S. bank stocks, more than 12% so far this year.

But there is one often overlooked sector of the banking industry that has outperformed considerably: custody banks. These are not like traditional banks that lend to consumers and businesses. They hold and service huge amounts of institutional assets -- such as mutual funds, pensions, exchange-traded funds (ETFs), stocks and other investments, real estate, cash, hedge funds, endowments, and 401(k)s -- all from large institutions.

They collect fees on these assets for servicing and holding them -- and those fees rise as the asset totals increase.

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In addition, custody banks hold clients' uninvested cash and pay a low deposit rate. But they aggregate cash and reinvest it in liquid, higher-yielding short-term instruments, profiting off the difference.

They also make money through securities lending, where they loan idle stocks and bonds from their clients to third parties -- like brokers or hedge funds -- to settle short sales or other trades. In exchange, the borrower provides collateral, typically bonds or cash, which the custody bank then invests and splits the return with the borrower.

In addition to custody services, all banks have asset management arms with a roster of ETFs, funds, and separate accounts. State Street (NYSE: STT), one of the largest custody banks, runs the SPDR funds through its asset management arm.

It is a very sturdy, all-weather business dominated by a few major players. Right now, the leading custody banks, State Street, BNY Mellon (NYSE: BNY), and Northern Trust (NASDAQ: NTRS), are firing on all cylinders.

Custody banks near all-time highs

The top custody banks are all significantly outperforming other bank stocks and hovering near all-time highs. State Street is up 32% this year, while BNY Mellon has gained 26%, and Northern Trust has rallied 29%.

BNY Mellon is the largest custodian bank, overseeing some $59 trillion in client assets. It also manages $2 trillion in assets. In the first quarter, BNY Mellon reported record revenue of $5.4 billion, up 13% year over year. Fee income rose 12% year over year to $3.8 billion, while net interest income jumped 18% to $1.4 billion. Further, net income spiked 36% to $1.6 billion, while earnings rose 42% to $2.24 per share.

What sparked the surge in revenue despite a rocky first quarter? A few factors benefited BNY Mellon and custody banks that did not apply to traditional consumer banks.

BNY Mellon attracted more deposits and client assets, as more of its large clients made a flight to safety during a volatile quarter. They sought the safety of parking their cash and gaining interest. This helped BNY Mellon increase assets under custody (AUC), which boosted fee income. Custody assets rose 12%, and average deposits surged 13% year over year.

In addition, BNY Mellon saw a spike in trading and foreign exchange income because, during volatile markets, the number of transactions by pensions and funds increase to rebalance and make changes to their portfolios. Further, the high interest rates on short-term bonds and investments in which BNY Mellon invested its assets helped raise spreads and net interest income.

I'm using BNY Mellon as an example, but the other major custody banks had similar results.

These custody banks will release their Q2 earnings in the coming weeks. BNY Mellon reports earnings on July 15, followed by State Street on July 16 and Northern on July 22.

All three stocks are buys heading into earnings because they are relatively cheap, are stable businesses as the dominant players among a small group of competitors that collect fees no matter the market environment, and aren't as reliant on net interest income. But with the S&P 500 (SNPINDEX: ^GSPC) rising almost 15% in Q2, these custody banks should see AUC and revenue surge to perhaps new records.

Dave Kovaleski has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.