Bank Bonds Poised to Recapture Pre-Crisis Yield EminenceMadhura Karnik and Dakin Campbell
Banks are poised to overtake industrial companies as the safest borrowers in the $5.1 trillion U.S. corporate bond market for the first time since the start of the worst financial crisis since the Great Depression.
Investors demand an extra 154 basis points in yield over benchmarks to buy bonds of JPMorgan Chase & Co., Wells Fargo & Co. and other lenders, compared with 138 basis points for companies from Alcoa Inc. to Ford Motor Co., Bank of America Merrill Lynch index data show. At 16 basis points, the gap has shrunk from a peak of 365 in 2009 and may invert as soon as this year based on the current pace of tightening.
Banks have responded to calls from the U.S. Congress to the Basel Committee on Banking Supervision to rebuild their capital cushions, increasing their ratio of core capital to assets by more than two-fold since the peak of the crisis.
“Financial institutions are a favored sector for investment-grade investors,” Edward Marrinan, a macro credit strategist at RBS Securities in Stamford, Connecticut, said in a telephone interview. Following legislative and regulatory changes, “their balance sheets are far more conservatively funded,” he said.
Their 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.
Bond buyers are wagering lenders are safer relative to industrial companies even after Moody’s Investors Service cut the ratings of 15 of the world’s largest banks last June, citing fragile confidence and tighter regulations that pinched revenue.
Of the 31 financial institutions in the Standard & Poor’s 500 index that have reported fourth-quarter earnings, 87 percent showed earnings growth, the most of any industry, according to data compiled by Bloomberg.
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 0.9 basis point to a mid-price of 85.8 basis points as of 11:25 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically rises as investor confidence deteriorates and falls as it improves. The contracts 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.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, increased 0.68 basis point to 16.63 basis points as of 11:25 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.
Bonds of Charlotte, North Carolina-based Bank of America Corp. are the most active dollar-denominated corporate securities today, accounting for 4.1 percent of the volume of dealer trades of $1 million or more as of 11:26 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Spreads on bank bonds have shrunk 230 basis points since the end of 2011, more than three times the 68 basis-point tightening for industrial debt, Bank of America Merrill Lynch index data show. In the same period, bank bonds have returned 15.2 percent, compared with 7.7 percent for industrial debt.
Average relative yields on JPMorgan bonds have declined 151 basis points since the end of 2011 to 115 basis points, versus a tightening of 42 basis points to 134 for Dallas-based AT&T Inc., the second-biggest U.S. wireless carrier, Bank of America Merrill Lynch index data show.
“While much of the U.S. bank universe is trading close to its post-crisis tights, we believe there is room for further tightening” for firms including Morgan Stanley and Goldman Sachs Group Inc., Barclays Plc analysts Jeffrey Meli and Bradley Rogoff in New York wrote in a report dated Jan. 25.
Goldman Sachs reported a quarterly profit on Jan. 16 that beat estimates and full-year revenue that grew for the first time since 2009. Two days later, Morgan Stanley, owner of the world’s biggest brokerage, said fourth-quarter earnings from that business more than doubled and the firm reached profit-margin targets six months ahead of schedule.
For all the concern that financial debt would be roiled by the Moody’s downgrades on June 21, bank bonds have gained 7.8 percent since the cuts, compared with 3.5 percent for industrial debentures, Bank of America Merrill Lynch index data show.
The Federal Reserve’s efforts to lift the economy by accelerating purchases of mortgage-backed securities by $40 billion a month for its third round of so-called quantitative easing is creating a shortage of assets that sends investors reaching for more yield, Pri de Silva, a bank analyst at New York-based CreditSights Inc., said in a telephone interview.
“When financials are wider than industrials, the demand for financials increases,” de Silva said.
The panic that eventually led to $2 trillion in writedowns and losses at the world’s largest banks began on Aug. 9, 2007, after Paris-based BNP Paribas halted withdrawals from three investment funds that had declined 20 percent in less than two weeks because it couldn’t “fairly” value their holdings.
Thirteen months later, Lehman Brothers Holdings Inc., the biggest underwriter of mortgage-backed securities as the U.S. real estate market peaked, filed for the largest bankruptcy in history, and credit markets froze. Goldman Sachs and Morgan Stanley were forced to transform into bank holding companies.
A global effort to bolster banks’ balance sheets followed. The Dodd-Frank Act passed in July 2010 overhauled U.S. financial rules in a bid to avoid another financial collapse.
New capital rules announced by the Basel committee called for tighter capital structures, specifically in Tier 1 capital, a measure of lenders’ ability to withstand losses, which regulators said should be composed mostly of common stock and retained earnings.
The average Tier 1 common equity at the four largest banks, JPMorgan, Bank of America, Citigroup Inc. and Wells Fargo, was 11.22 percent of risk-weighted assets at year-end, up from 4.31 percent in December 2008, Bloomberg data show.
The new capital rules may force the largest lenders to hold equity that’s as much as 9.5 percent of risk-weighted assets. The four banks, plus Goldman Sachs and Morgan Stanley, had a Tier 1 common ratio under the stricter rules of 8.89 percent at the end of 2012, up from 8.03 percent at the end of June, Bloomberg data show.
“In the past few years banks have been diligent in reinforcing their capital structure and have more conservative balance sheets,” Dorian Garay, a New York-based money manager for an investment-grade debt fund at ING Investment Management, said in a telephone interview.