Bloomberg News

Pimco, Neuberger Defy Bank Bond ‘Pain Threshold’: Credit Markets

September 29, 2011

Sept. 29 (Bloomberg) -- Bond managers from Pacific Investment Management Co. to Neuberger Berman Management LLC are sticking with bets that U.S. banks will withstand a European crisis that’s triggered the biggest losses since early 2009.

More than half of investors said they were “comfortable” holding bank bonds versus non-financial securities, even after the debt underperformed by 6.9 percent since April, according to a JPMorgan Chase & Co. survey. Only 7 percent of the investors said they were “unwinding” positions, JPMorgan strategists wrote in a Sept. 26 note.

Some of the world’s biggest debt investors say U.S. bank balance sheets have been fortified enough since the 2008 failure of Lehman Brothers Holdings Inc. to weather the sovereign-debt crisis that now threatens to infect Europe’s banking system and derail the U.S. economic recovery. That’s giving them confidence to ride out losses of 3.6 percent since the end of July, the biggest slide in 30 months, on lenders from Bank of America Corp. to Morgan Stanley.

“We understand and are respectful of the volatility due to issues out of Europe and concerns about U.S. economic growth, but for long-term value, U.S. money-center banks are a good option,” David Brown, a money manager at Neuberger Berman in Chicago, which oversees more than $85 billion in fixed-income assets, said in a telephone interview. They’ve “done a great job improving their capital position and their asset quality has continued to improve.”

‘Pain threshold’

Pimco’s Mark Kiesel, global head of corporate bond portfolios at the manager of the world’s biggest bond fund, said in a note on the company’s website last week that investors should be buying U.S. bank debt, while cutting risk elsewhere. Kiesel didn’t respond to an e-mail and a telephone call to elaborate.

While the bets should pay off in the long-term, losses may continue, JPMorgan strategists led by Eric Beinstein in New York said. That’s bringing investors closer to a “pain threshold” at which point some could seek to limit additional declines, exit the trade, and cause a further slump, they said.

Elsewhere in credit markets , Deutsche Bank AG completed the first public, senior unsecured bond sale from a European lender in more than two months, ending what was the longest period without a deal. A gauge of U.S. corporate credit risk declined, while a measure of banks’ reluctance to lend to one another in Europe rose for the first time in four days.

Deutsche Bank, Germany’s biggest lender, issued 1.5 billion euros ($2.05 billion) of floating-rate notes due October 2013 that were priced to yield 98 basis points more than the three- month euro interbank offered rate, according to data compiled by Bloomberg. The Frankfurt-based bank paid a spread of 40 basis points to issue two-year securities in February.

Credit Risk

The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, fell 1.7 basis points to a mid- price of 139.5 basis points as of 11:40 a.m. in New York, according to Markit Group Ltd.

The measure, which has declined 5.7 basis points since Sept. 22, decreased as government data tempered concern the U.S. economic recovery is in jeopardy. The economy grew at a 1.3 percent pace in the second quarter. Applications for jobless benefits dropped by 37,000 in the week ended Sept. 24 to 391,000, the fewest since April.

The Markit iTraxx Europe Index of credit-default swaps linked to 125 companies with investment-grade ratings fell 4.1 basis point to 189.1, Markit prices show.

The indexes typically fall as investor confidence improves and rise as it deteriorates. 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.

Euribor-OIS

The Euribor-OIS spread, the difference between three-month Euribor and overnight index swaps, widened to 81 basis points from 78 yesterday, Bloomberg data show. The gap reached a 2 1/2- year high of 89 on Sept. 23.

In emerging markets, relative yields fell 6 basis points to 441 basis points, or 4.41 percentage points, according to JPMorgan’s EMBI Global index. The index has expanded from 259 basis points on Jan. 5.

Bond traders are demanding the biggest premiums in two years to hold financial company debt instead of bonds of industrial companies, according to Bank of America Merrill Lynch index data.

‘Much Better Shape’

Financial debt is trading at 340 basis points more than Treasuries, 130 basis points more than the 210 basis-point spread for industrial bonds, index data show. The gap reached 132 basis points on Sept. 23, the widest since September 2009.

Pimco’s Kiesel has advocated for much of the past two years that investors buy the senior debt of U.S. lenders. Bank of America and Citigroup Inc. were poised to be “two of the stars” in fixed-income markets this year, Kiesel said in December. Senior-ranked bank bonds are among a handful of assets that remain a safe bet “given strengthening capital and balance sheets,” he said in the note last week.

Investors generally should be holding greater amounts of cash and avoiding the most indebted companies as the economy slows, the Newport Beach, California-based manager said in the note.

U.S. banks “are in much better shape than they were pre- financial crisis, and Basel 3 requirements are only going to improve that strength,” said Brian Machan, a money manager at Aviva Investors North America in Des Moines, Iowa, where he helps oversee $57 billion. Machan was referring to new international capital standards set by the Basel Committee on Banking Supervision.

Capital Cushions

The weighted average Tier 1 capital ratio for banks in a JPMorgan index, a measure of the lenders’ financial strength, climbed to 12.2 percent in the second quarter, the seventh straight quarterly increase and a 60 percent improvement over the past four years, JPMorgan strategists said in a note to clients last month.

“Capital raises, write-downs and general de-risking of balance sheets have made U.S. banks harder to topple,” Marc Pinto, head of corporate bond strategy at broker-dealer Susquehanna Financial Group said in a Sept. 19 note to clients. That’s “even if their European counterparts, which had been similarly reinforced (except with respect to funding), now face a new potential series of sovereign debt writedowns and liquidity challenges,” he wrote.

The increased capital cushions are doing little to ease broader market concerns as Federal Reserve data show corporate bond holdings by Wall Street dealers plunge to the lowest since April 2009. Bank of America bonds lost 5.5 percent this month and Morgan Stanley debt declined 3.9 percent, Bank of America Merrill Lynch index data show.

Two Years of Liquidity

Bank of America’s $1.5 billion of 5.875 percent, notes due in January 2021 that were issued in December have declined 5.2 cents to 94.1 cents on the dollar as of yesterday, Trace data show. Its stock has also plunged this year on both the European crisis and concerns that it faces larger losses tied to faulty mortgages.

The lender had a record $402 billion of liquidity at the end of the second quarter, spokesman Jerry Dubrowski said.

“We have roughly two years worth of liquidity on hand to fund our business operations without having to go to the market,” Dubrowski said in a telephone interview. “We did that in part because we wanted to be somewhat insulated from the volatility of the market and be able to fund.” Bank of America doesn’t comment on stock and bond movements, he said.

“Simply adding capital right now to already conservative balance sheets will not be sufficient for spreads to improve,” Neuberger Berman’s Brown said. “We must see some resolution and clarity to the risks in Europe and potential liabilities from legacy mortgage loans.”

DoubleLine Avoids Banks

DoubleLine Capital LP, the $17 billion investment firm run by Jeffrey Gundlach, is avoiding U.S. banks in a bid to avert losses stemming from the region’s fiscal imbalances.

Thomas Chow, a senior money manager who helps invest $120 billion of fixed-income assets at Philadelphia-based Delaware Investments, said investors need to be cautious with the trade, “especially given the kind of news that can move these sectors around quite a bit.”

“Those who have held onto this trade for a long time,” he said, are “certainly feeling it much more.”

Money managers holding the debt will likely be able to endure bigger losses than the hedge funds and bank proprietary trading units that in 2008 unloaded assets as declines accelerated, said JPMorgan’s Beinstein in New York.

“When high-grade bonds were more heavily owned by hedge funds and bank prop desks, they were more short-term focused, and when the positions weren’t working they would unwind them more quickly,” Beinstein said in a telephone interview. “Now most high-grade bonds are held by asset managers and insurance companies. They’re long-term investors, and when they believe in something they are generally able to hold it for quite some time. That’s why it’s difficult to determine the pain threshold at which they would unwind.”

----With assistance by Ben Martin in London. Editors: Pierre Paulden, Alan Goldstein

To contact the reporters on this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Sapna Maheshwari in New York at sapnam@bloomberg.net

To contact the editor responsible for this story: Alan Goldstein at agoldstein5@bloomberg.net;


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