Bank Debt Swaps Headed for Biggest Monthly Drop Since April ‘08

An index of credit-default swaps insuring against losses on European bank bonds is heading for the biggest monthly drop since April 2008.

The Markit iTraxx Financial Index linked to 25 banks and insurers has fallen 43.5 basis points this month and is near the lowest level since April 23. The gauge pared the decline today, rising 3.5 basis points to 118.5, according to JPMorgan Chase & Co. prices at 1:30 p.m. in London.

The cost of swaps on bank bonds will fall, according to BNP Paribas SA, after European Union stress tests boosted confidence that lenders can withstand an economic slowdown. Investor sentiment has also been buoyed by the softening of proposed capital and liquidity rules by the Basel Committee on Banking Supervision.

“We believe the best course of action for investors is to go with the flow,” said Aziz Sunderji, a London-based strategist at Barclays Capital. “We would advise investors to spend the remainder of the summer adding risk.”

Lenders rushed to sell bonds in euros this week to take advantage of improved risk appetite, with Banco Bilbao Vizcaya Argentaria SA issuing 1.25 billion euros of five-year notes and Bank of America Corp. selling a 2 billion-euro ($2.6 billion) seven-year deal.

Company bond sales in Europe fell 24 percent in July to 40.6 billion euros, compared with 53.7 billion euros in June, according to data compiled by Bloomberg. Issuance is down from 79 billion euros in the same period in 2009.

Swaps Rally

The credit-default swap rally eased ahead of a report that may show the U.S. economy grew in the second quarter at about the same pace as in the prior three months, driven by a pickup in business investment as consumer spending cooled.

The U.S. financial system remains fragile and banks subjected to additional economic stress might need as much as $76 billion in capital, according to the International Monetary Fund.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose 2.25 basis points to 107, JPMorgan prices show. The index, which also includes banks and insurers, fell 21.5 basis points this month, the most in a year, and may drop as low as 90 basis points next month, according to analysts at BNP Paribas SA.

The difference between Markit’s financial and corporate gauges shrank to near the least since March this month, dropping as low as 7.75 basis points July 27. The Markit iTraxx Financial Index now exceeds the corporate benchmark by 10.5 basis points. The gap may disappear, Alberto Gallo, a strategist at Goldman Sachs Group Inc. said July 13.

‘A Kind Month’

“July has been a kind month for the credit markets as spreads have tightened,” said Juan Esteban Valencia, a London-based credit strategist at Societe Generale SA. “The economic recovery showed some mixed results but the earnings season is proving once again to be quite strong giving support to the spread rally.”

Credit-default swap indexes stayed higher after a U.S. Commerce Department report that showed the world’s largest economy grew more slowly than forecast in the second quarter. Gross domestic product increased 2.4 percent year-on-year, compared with a 2.6 percent forecast of economists surveyed by Bloomberg News.

Contracts on the Markit iTraxx Crossover Index of 50 companies with mostly high-yield credit ratings increased 9.5 basis points to 489.

A basis point on a credit-default swap protecting 10 million euros of debt from default for five years is equivalent to 1,000 euros a year. The contracts pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements.

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