June 22 (Bloomberg) -- The bond market is falling in love again with Goldman Sachs Group Inc. and Morgan Stanley and, for the first time in more than nine months, is giving these Wall Street icons a chance to close the gap with JPMorgan Chase & Co.

In the two days after Lehman Brothers Holdings Inc. went bankrupt last September, Goldman Sachs’s 5.95 percent bonds due January 2018 paid investors as much as 6.32 percentage points more than similar-maturing Treasuries, or double what they yielded a week earlier. Morgan Stanley’s bonds were even worse, widening to 800 basis points. The surge in credit costs, the most both companies have experienced, cast doubt on a business model that relied on debt-market funding.

Now, bondholders are accepting the smallest difference in yield for the New York-based banks’ bonds relative to Treasuries since before Lehman Brothers collapsed. Goldman Sachs and Morgan Stanley, which were among 10 banks that last week repaid loans from the U.S. Treasury, are emerging from the credit freeze with lower leverage and a stronger competitive position.

“They’re back on their feet,” said Joseph Balestrino, a fixed-income market strategist at Federated Investors Inc. in Pittsburgh, which manages $26 billion in debt assets and has an overweight position in Goldman Sachs and Morgan Stanley bonds relative to benchmark indexes. “We removed the excessively cheap valuations that we had in the marketplace. Things were really wide, pricing in Armageddon.”

Most Since Milken

After the Lehman Brothers bankruptcy on Sept. 15, the premium investors charged to buy the riskiest categories of corporate debt compared with Treasury bonds widened the most since Michael Milken created the market for low-rated, or “junk,” bonds in the 1980s, according to the Merrill Lynch U.S. High Yield Master II Index, which tracks data to 1986.

Morgan Stanley, which had more than $200 billion of bonds outstanding at the time, started fielding calls from investors who wanted to sell them back in the days after Lehman Brothers collapsed. Chief Financial Officer Colm Kelleher spoke almost hourly about the firm’s liquidity and funding with Group Treasurer David Wong, as well as with Tom Wipf, who runs secured financing, and Stephen O’Connor, head of collateral management, according to a person with knowledge of the situation.

The company repurchased $12.3 billion of its debt by the end of November in an effort to limit price declines, Kelleher told analysts on Dec. 17.

Perception Shift

Goldman Sachs CFO David Viniar, who was preparing to report his firm’s third-quarter earnings the day after Lehman went bankrupt, mobilized hundreds of employees around the world to comb through the firm’s funding and collateral agreements to ensure it would have enough cash available, according to a person familiar with the matter.

Spokesmen for both companies declined to comment.

A week after Lehman Brothers’s bankruptcy, Goldman Sachs and Morgan Stanley converted themselves from the biggest U.S. securities firms into banks and pledged to attract deposits, which were viewed as a cheaper and more reliable funding source than the bond market. They began relying on Federal Deposit Insurance Corp. guarantees in November to lure bondholders.

Goldman Sachs issued about $30 billion of government- guaranteed bonds from November to March, and Morgan Stanley sold about $25 billion, company reports show.

The companies each returned last week the $10 billion that they received from the Treasury on Oct. 13. Morgan Stanley said it doesn’t plan any more guaranteed issues.

Narrowing Spreads

“The perception of the two companies has changed in the last few months,” said Ricardo Kleinbaum, a credit analyst at BNP Paribas SA in New York. “I don’t think there’s a sense anymore that you have to have a retail deposit base or be part of a bank to survive, and credit spreads are telling you that.”

The risk premium, or spread, that investors charge to hold Goldman Sachs’s $3.2 billion of senior unsecured 5.95 percent 2018 bonds instead of U.S. Treasury debt with a similar maturity fell below 300 basis points this month for the first time since Sept. 10, according to data compiled by Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The spread on Morgan Stanley’s $4.5 billion of senior unsecured 6.625 percent 2018 notes, which widened to more than 1,000 basis points in mid-October, dropped below 302 basis points on June 10, its lowest level in almost a year. A basis point is one-hundredth of a percentage point.

Both companies are benefiting from a rally in corporate debt and a perception that the worst is behind them after the Federal Reserve completed so-called stress tests last month. The regulators required some banks, including Morgan Stanley, to sell stock to raise more capital.

‘Fear Went Away’

“Back in the middle of a credit crisis, that business model doesn’t necessarily work so well,” said Derek Brown, director of fixed income at Transamerica Investment Management in Los Angeles, who helps oversee $6.2 billion. “Now I think that liquidity concern has been alleviated, and their business model is slightly more robust.”

Morgan Stanley has raised $6.92 billion in the stock market since the beginning of May and reduced its dividend to save about $1 billion a year. Goldman Sachs sold $5.75 billion of stock in April and reported better than estimated first-quarter results on strong gains from fixed-income trading.

Goldman Sachs climbed 70 percent in New York Stock Exchange composite trading this year, after dropping 61 percent in 2008. Morgan Stanley advanced 76 percent, rebounding from last year’s 70 percent slump.

“My fear went away and I started to buy,” said William Larkin, a fixed-income fund manager who helps oversee $475 million at Cabot Money Management in Salem, Massachusetts, and bought Goldman bonds last month. “As long as the markets are functioning properly, they’ll make lots of money.”

Earnings Adjustments

For companies like Goldman Sachs and Morgan Stanley that rely on leverage, the interest they need to pay on their debt matters more than the price of their stock. If Goldman had to pay 10 percent to borrow for five years, the rate the market was charging in September, it would struggle to generate enough revenue to cover its costs. At today’s rate of about 4.79 percent, the cost is more manageable.

While lower credit spreads typically help earnings, both firms have sold structured notes tied to their own debt that have to be marked to market. The increase in the value of those liabilities results in an accounting charge that hurts profit. In the first quarter, such debt valuation adjustments led Morgan Stanley to take a $1.5 billion charge.

Commercial Banks

Goldman Sachs’s and Morgan Stanley’s credit spreads are narrower than those for commercial banks such as Bank of America Corp. in Charlotte, North Carolina, and New York-based Citigroup Inc., reflecting concerns that the recession will lead to further losses on credit cards, consumer loans and real estate.

Neither Bank of America, the nation’s biggest mortgage lender at the end of last year, nor Citigroup, the third-largest U.S. bank by assets, has been able to return aid they received from the government.

The spread on Citigroup’s $3 billion of 6.125 percent 2018 senior unsecured notes is 463 basis points relative to Treasuries, while Bank of America’s $4 billion in 5.65 percent senior unsecured 2018 notes is about 389 basis points.

JPMorgan, like Goldman Sachs and Morgan Stanley, repaid the Treasury’s bailout fund last week in a step toward avoiding government restrictions on lending and pay.

The risk premium in the credit markets for New York-based JPMorgan, the largest U.S. bank by market value, is less than for Goldman Sachs and Morgan Stanley. The spread on JPMorgan’s $3 billion of 6.3 percent senior unsecured 2019 notes was 256 basis points at the end of last week relative to Treasuries, compared with 295 basis points for Goldman Sachs’s 2019 notes and 325 basis points for Morgan Stanley’s 2019 notes.

Blankfein Bounce

Richard Lee, a managing director in the fixed-income trading department of closely held broker-dealer Wall Street Access in New York, said his trading book lost money on Lehman Brothers bonds when that company failed. Now he said investors should be demanding higher risk premiums for Goldman Sachs and Morgan Stanley because, even if they’re in better shape than they were nine months ago, their bonds are more vulnerable to market upheaval.

“There are so many time bombs that can blow up,” said Lee, who’s shorting, or betting against, financial bonds. “People are somewhat minimizing the risks of owning the paper at this spread.”

Cabot’s Larkin said he bought Goldman Sachs bonds after watching Chief Executive Officer Lloyd Blankfein deliver a speech to the Council of Institutional Investors in April that persuaded him the company was emerging from the crisis in a strong competitive position.

‘Bit of Yield’

The 5.25 percent 2013 senior unsecured bonds he bought last month narrowed to yield 195 basis points more than Treasuries at the end of last week, down from 317 basis points in mid-May. Larkin said he isn’t a buyer at current levels.

“I’m just shocked at how expensive everything’s gotten,” Larkin said in an interview last week.

Gary Jenkins, head of credit research at Evolution Securities Ltd. in London, said there’s no clear answer yet on whether the two companies will be able to revert to their old model of relying on debt-market funding.

“In the last few months, we’ve clearly been in a rallying market, and anything with a bit of yield and spread has been seen as the thing to buy,” he said. “There will be a time when that either stabilizes or turns around, and the big question is will there be ongoing demand for these institutions?”

To contact the reporter on this story: Christine Harper in New York at charper@bloomberg.net.

Last Updated: June 21, 2009 19:01 EDT