Pimco, Wells Capital Buy Bank Bonds That Look Cheap After Rout

  • Buyers believe banks face pressure to profits, not credit risk
  • Issuance could be light after earnings because of TLAC

One of the hottest corporate bond trades of 2015 could heat up again. 

Fund managers including Wells Capital Management Inc. and Pacific Investment Management Co. are buying notes issued by U.S. banks, which look inexpensive compared with debt issued by industrial companies. Some investors are drawn to the bonds after JPMorgan Chase & Co. posted better-than-expected results on Wednesday, kicking off earnings season for major banks.

Demand from money managers is the latest sign that the turmoil that roiled markets globally in January and February has abated. Any difficulties that banks might be having now, including bad energy loans or weak trading revenue, will probably have more of an impact on their earnings than on their ability to pay their bonds, said Jim Paulsen, chief investment strategist at Wells Capital.

"Banks are a value opportunity," Paulsen said. Wells Capital, a unit of Wells Fargo & Co., has $349 billion of assets under management. 

JPMorgan said first quarter profit fell 6.7 percent, as stock and bond underwriting fees and trading revenue dropped. But earnings per share, adjusted for special items, beat analysts’ estimates.

"We’re going to get bad reports but we’re not going to reach the nightmare-type things people feared going into this earnings season," Paulsen said.

‘Profitability Challenge’

Analysts are forecasting weaker income for all of the biggest banks as trading and investment-banking revenue drop.

"Banks have a profitability challenge," said Mark Kiesel, chief investment officer at Pimco. But with tighter regulations and higher capital requirements for financial companies, "the bondholder continues to win," he said, speaking before JPMorgan posted its earnings. Pimco has $1.4 trillion of assets under management. 

Pimco has been buying bonds in the sector over the last month, mostly senior unsecured notes, but has become more selective in recent days after the debt has rallied, Kiesel said. He is looking more closely at British banks, which have grown cheaper in recent weeks amid fears that the U.K. will leave the European Union.

Banks often issue bonds just after earnings, but that activity could be relatively light this quarter, because many lenders are waiting for more detail about new regulations later this year before issuing, strategists said. When finalized, the rules known as the Total Loss Absorption Capacity requirements will force some banks’ holding companies to issue additional senior unsecured bonds.

If post-earnings issuance is weak, bank bond spreads may tighten further in the coming weeks, said Hans Mikkelsen, head of high-grade credit strategy at Bank of America Corp.

TLAC rules in Europe could also hurt senior bonds for some banks, said Juuso Rantala, a money manager at Aktia Fund Management in Helsinki.

"It’s so unclear to figure out how senior should price nowadays," Rantala said.

Investors that are loading up on U.S. bank bonds are coming back to a sector that was among the best performing of 2015. Bank bonds trounced investment-grade and junk debt, not to mention the Standard & Poor’s 500, in 2015 on a total return basis. 

At the beginning of 2016, financial debt got punished. Slowing growth in China and falling oil prices raised fears that loan defaults for banks would jump. Analysts forecast that Deutsche Bank AG could have trouble paying coupons on its riskiest bonds. Risk premiums on banks’ bonds jumped to their widest levels since 2012, according to data compiled by Bank of America Merrill Lynch.

Since then, Japan’s and Europe’s central banks have pumped more money into their economies, and the price of oil has stabilized. Deutsche Bank said it would buy back up to $5.4 billion of bonds to bolster investor confidence.

Banks Lag

Those factors have helped investment-grade corporate bonds in general in recent weeks -- spreads over Treasuries narrowed more than 0.5 percentage point to 1.66 percentage point between Feb. 11 and Monday, according to Bank of America Merrill Lynch data.

Bank bonds have tightened by just 0.34 percentage point over that same period. 

The gap between yields for banks and industrial companies illustrates how much financial bonds have lagged other investment-grade notes. Debt from lenders now yields an average of 0.23 percentage point more than that of manufacturers and related companies when comparing notes with similar maturities, the widest gap since mid-2014.

In the U.S., the outlook for interest rates could be weighing on bank bonds, said Tom Murphy, a money manager at Columbia Threadneedle Investments, which has $176 billion of assets under management. In recent weeks, the Fed has signaled that it will be slower to raise rates because the economic outlook has weakened. Higher rates are expected to boost bank profitability by lifting the interest they earn on loans.

At the beginning of March, fed fund futures implied a 38 percent chance of an increase in June, a figure that is now closer to 18 percent.

The Fed’s plans may end up helping the sector, Wells Capital’s Paulsen said. Usually, bond investors fear that rate hikes will slow the economy and weigh on the bonds, he said. It is unusual for financial notes to perform worse when the central bank is holding off on tightening. 

"It’s an opportunity at the moment to buy up something that’s maybe not turning out as bad as people feared," Paulsen said.

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