Banks Prove Safer Than Industrials in Bond Rally: Credit Markets
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For the first time since before the credit crisis, bond buyers are demonstrating more confidence in the U.S. banking system than in industrial companies as lenders fortify balance sheets while firms from Verizon Communications Inc. (VZ) to Apple Inc. (AAPL) borrow record amounts.
Relative yields on bonds from Citigroup (C) Inc. to JPMorgan Chase & Co. (JPM) were 3 basis points less than the average for industrial notes last week, the first time since September 2007 that investors didn’t require more from bank borrowers, Bank of America Merrill Lynch index data show. The relationship reversed after bank bond spreads surged to an unprecedented 365 basis points more than industrials amid the worst financial crisis since the Great Depression.
Lenders sitting on a record $9.5 trillion of deposits are winning over the bond market after increasing a measure of their capital cushions by about 54 percent to meet regulations intended to prevent a repeat of the turmoil that followed the 2008 bankruptcy of Lehman Brothers Holdings Inc. and contributed to more than $2 trillion of writedowns and losses at the world’s biggest financial institutions.
“These are the cleanest balance sheets we’ve seen in a generation,” said Mark Kiesel, global head of corporate bond portfolios at Newport Beach, California-based Pacific Investment Management Co., which oversees $1.97 trillion as the world’s biggest bond-fund manager. “Banks were being forced by regulators to act in the best interest of bondholders,” said Kiesel, who began calling for a rally in the bonds in 2009.
Spreads on the debt of Citigroup, which took its last step in eliminating a $7 billion government stake this month after receiving more bailout assistance than any other U.S. lender, have dropped to 137 basis points from 806 basis points in April 2009. The third-biggest U.S. bank by assets boosted its tangible common equity ratio, a measure of its ability to absorb financial shocks, to 8.72 percent in the second quarter from 1.66 percent at the end of March 2009, according to Bloomberg Industries.
Spreads on JPMorgan, the nation’s biggest bank, have fallen to 115 from 500, or 5 percentage points, during the same period as it increased its equity ratio to 6.18 percent from 4.18 percent during the same period.
As banks bolster their balance sheets, corporate debt loads are approaching the highest levels since 2009 as treasurers tap the bond market to fund acquisitions and shareholder rewards before the Federal Reserve starts scaling back stimulus that pushed borrowing costs to record lows.
Corporate debt levels have increased faster than cash flow for six straight quarters, boosting the obligations of investment-grade companies in the second quarter to 2.09 times, according to an Aug. 23 report by JPMorgan credit strategists. That’s up from 2.07 times in the first three months of 2013 and compares with 2.13 in the third quarter of 2009.
“You have a dichotomy of environments,” said Thomas Urano, a money manager at Austin, Texas-based Sage Advisory Services Ltd., which oversees about $10 billion and favors financial bonds over industrial debt. “The regulatory environment is kind of prohibiting re-leveraging in finance, and on the industrial side the credit fundamentals make it attractive to.”
The extra yield investors demand to own bank debt instead of similar-maturity Treasuries was 149 basis points on Sept. 20, compared with a spread of 152 on industrial notes, the Bank of America Merrill Lynch index data show.
Globally, spreads on bank debt of 145 basis points are 4 more than those of industrial notes, index data show.
Bank bonds were seen as safer than industrial debt by investors until September 2007, the month after BNP Paribas SA marked the start of the credit seizure by halting withdrawals from investment funds that owned subprime mortgage securities.
Lender spreads averaged 82 basis points, or 55 less than those for industrial companies, in the five years before 2007, when a collapse of the U.S. housing market triggered failures of lenders from Lehman to Washington Mutual Inc. Spreads reached 823 basis points on bank securities in March 2009 and 603 for industrial debt in December 2008, both all-time highs.
Dollar-denominated bank debt has returned 9 percent annually since the end of 2008, compared with 9.2 percent for securities of non-financial firms, the index data show.
Investors started to regain confidence as the Fed began stimulus efforts that expanded its balance sheet by $2.8 trillion since Lehman’s collapse and the U.S. government stepped up rescue efforts including the Federal Deposit Insurance Corp.’s Temporary Liquidity Guarantee Program that backed new senior unsecured debt.
Increased banking standards announced in 2010 by the 27-country Basel Committee on Banking Supervision pushed lenders to boost capital measures that regulators track to determine their ability to withstand losses. In the U.S., Congress passed the Dodd-Frank Act seeking to restrict the risks banks take with their own money.
The average tangible common equity ratio for North American banks climbed to 8.57 percent in the second quarter from 5.58 percent in the fourth quarter of 2008, according to Bloomberg Industries.
Lenders have increased deposits 37 percent since the end of 2008, while borrowings from money market funds and other short-term sources that all but froze during the credit crisis have decreased 23 percent to $1.35 trillion, Bloomberg Industries data show. Deposits exceed lending at U.S. banks by an unprecedented $2.2 trillion, Fed data show. Obligations were $135.9 billion more than deposits at the end of 2007.
“Banks are going to be in really good shape going forward,” given the tougher regulation, Matthew Duch, who helps oversee $12 billion as a money manager at Bethesda, Maryland, Calvert Investments Inc., said in a telephone interview. “Profitability may not be as strong, so maybe it’s not an equity story,” he said. “But from a debt perspective, you feel pretty good.”
Bank confidence was boosted again this week as the Fed refrained from trimming its $85 billion of monthly bond purchases, Fitch Ratings said in a Sept. 18 report.
“Sustained asset purchases and slow loan growth have created a large deposit cushion for banks,” analysts at the ratings company said. “U.S. bank liquidity will remain near record levels, as securities held on the Fed’s balance sheet continue to grow.”
Bank debt also is benefiting as investors seek securities that are less vulnerable to rising interest rates as the Fed considers scaling back bond buying that pushed yields on corporate bonds from the riskiest to the most creditworthy borrowers to a record-low 3.35 percent in May. Yields climbed to 4.09 percent on Sept. 20.
A measure of that rate sensitivity, known as effective duration, was 4.56 for securities issued by lenders, compared with 6.94 for industrial bonds, Bank of America Merrill Lynch index data show.
The same measures that helped to mend the banking system enabled companies in the U.S. to issue $6.1 trillion of bonds since 2008 to extend maturities, lower interest expense and finance mergers and acquisitions.
Sales of $1.1 trillion in the U.S. this year follow unprecedented offerings of $1.47 trillion in all of 2012, Bloomberg data show. The share of bank bonds in the overall market fell to 18 percent, its lowest in more than four years, with the share of industrial bonds rising to 48 percent, its highest ever, Bank of America Merrill Lynch index data show.
Verizon raised $49 billion of debt on Sept. 11, the biggest corporate bond offering ever, for its $130 billion deal with Vodafone Group Plc to take full control of its Verizon Wireless unit. The new debt more than doubled the New York-based company’s $49.2 billion of borrowings and raises its ratio of debt to earnings before interest, taxes, depreciation, and amortization to about 2 times from 1.6 times, after accounting for the increased cash flow from Vodafone’s 45 percent stake.
That offering surpassed a previous record $17 billion issue in April by Apple that was used to help fund a $100 billion capital reward for shareholders. The company had been debt-free since 2004 and saw its leverage increase to 0.3 times.
“We’ve seen a noticeable up-tick in shareholder activism, M&A risk and shareholder-friendly rewards,” Sage’s Urano said. “In our minds that puts the balance sheet and credit fundamentals at risk in the industrial sectors.”
The total amount of cash delivered to shareholders in the second quarter by investment-grade companies rose to $485 billion, a 1.5 percent increase from the previous period, JPMorgan data show. That’s 57 percent higher than the average over the past decade, though the level has declined from a year earlier, the analysts wrote.
While bank credit quality has improved as capital cushions increased, industrial “companies have a lot more freedom to take advantages of opportunities in low interest rates,” Kathleen Shanley, an analyst at debt researcher Gimme Credit LLC, said in a telephone interview. “We are seeing more freedom to leverage up and do acquisitions and buybacks.”
Elsewhere in credit markets, General Motors Co. (GM) plans to sell bonds in a three-part offering that will help the carmaker partially owned by the U.S. government repurchase $3.2 billion of preferred stock. Moody’s Investors Service lifted GM to investment grade. Issuers in the reviving market for U.S. mortgage securities are creating debt with features not seen since before the financial crisis that can increase risks for certain investors, Moody’s said in a report.
The cost of protecting corporate bonds from default in the U.S. and Europe rose in the second day of trading for new versions of benchmark credit-default swaps indexes.
Series 21 of the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, rose 0.9 basis point to 80.8 basis points as of 11:37 a.m. in New York, according to prices compiled by Bloomberg. That’s 8.8 basis points more than where the previous series is trading.
The Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 0.7 basis point to 100.1, or 9.7 more than the older contract, Bloomberg prices show.
New versions of Markit Group Ltd.’s indexes are created every six months. Companies are replaced if they no longer hold appropriate grades, aren’t among the most actively traded credit swaps or fail to meet other criteria. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Bonds of New York-based Verizon Communications Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 7.2 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
GM intends to issue five-, 10- and 30-year securities to help it buy back 120 million preferred shares from the United Auto Workers retiree health care trust, the Detroit-based company said today in a statement. The bond sale may price tomorrow, according to a person with knowledge of the transaction who asked not to be named because terms aren’t set. The new bonds will be rated Ba1, Moody’s said in a report.
The deal would come almost three years after the automaker, which filed for bankruptcy in 2009, repurchased $2.1 billion of the preferred stock from the Treasury Department. The UAW trust currently holds 260 million of the shares, GM said in the statement. Moody’s raised the corporate rating of GM to Baa3 from Ba1, citing expectations for an improved credit profile and competitive position, according to the report today.
The expanding ways in which investors in the various pieces of mortgage-bond deals will share cash flows from the underlying loans raise additional “analytical challenges,” Moody’s said today in a report. The structures are creating debt -- with names including super-senior support bonds, exchangeable securities, principal-only notes and pool interest-only bonds -- in which investors in some pieces can have greater losses even with the same levels of loan defaults and repayments.
After a previous generation of mortgage bonds without government backing helped fuel a global credit seizure, Moody’s said the quality of the underlying loans in new deals remains “strong” and their senior-ranked bonds “will only incur losses in low-probability scenarios.” At the same time, some of the revived features have been exacerbating the losses in older bonds, Moody’s analyst Kruti Muni said.
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