Bank Bonds Stay Strong Despite S&P Warning It May Cut Ratings

Returns on bonds issued by U.S. commercial and investment banks remain much stronger than the broader market, as investors digest the less onerous capital requirements being placed on the companies by the Federal Reserve.

The Fed said last week that it will require large U.S. banks to raise as much as $120 billion in debt that can be converted into equity if they falter. The market was relieved, as many participants feared that regulators would seek a higher number, according to CreditSights.

Bank obligations have outperformed the corporate debt market, gaining 2.03 percent this year, compared to a 1 percent loss in the Standard & Poor’s 500 Financials Index and more than six times increase in the broader investment-grade corporate bond market.

“The new Fed guidelines are a lot less onerous that a lot of people thought they would be, which means the big worry of having to sell a lot more debt isn’t as worrisome,” said Pri de Silva, senior banking analyst at CreditSights Inc. in New York. “Years of questions have been answered and it means certainty for banks and investors, and certainty is always good.”

The rule on total loss-absorbing capacity, or TLAC, is a key part of regulators’ efforts to avoid another financial crisis and could lead to a rash of downgrades by credit raters if the banks don’t respond.

JPMorgan Chase & Co., Bank of America Corp. and Citigroup Inc. and five other large U.S. banks may have their ratings cut by Standard & Poor’s on the expectation that the U.S. government is less likely to provide aid in a crisis, S&P said Monday in a statement. Wells Fargo & Co., Goldman Sachs Group Inc., Morgan Stanley, Bank of New York Mellon Corp. and State Street Corp. also had senior unsecured and nondeferrable subordinated debt ratings placed on negative credit watch, the credit grader said.

The altered outlook for how much the big banks will have to borrow is good news for current holders of their bonds, who won’t face as large a leverage increase as had been thought. The securities have been popular as increased regulation and seven years of near-zero interest rates have weakened the ability of banks to embark on shareholder friendly activities such as dividends, stock buybacks and takeovers.

The extra yield investors demand to hold all corporate bonds instead of Treasuries is near a two-year high when compared to bank-bond spreads. It’s likely to remain at or near that level, said de Silva.

“The goal posts for financials keep moving, and it’s only been good for bondholders of financials,” said Gary Cloud, a senior portfolio manager who helps oversee the $460 million Hennessy Equity and Income Fund at Financial Counselors Inc. “Every regulation just builds the credit protection.”