Bank bonds are outperforming every other industry this year as financial firms reduce their supply of debt and boost capital to meet new risk-curbing regulations.
Bank of America Corp. (BAC:US) and Lloyds Banking Group Plc (LLOY) lead 8.1 percent returns on dollar-denominated bank notes since year-end, versus 5.4 percent on non-financial bonds, according to Bank of America Merrill Lynch index data. Last year, bank bonds were the worst performers, gaining 1.71 percent.
Lenders responding to the Dodd-Frank and Basel III financial-regulation overhauls are reducing the amount of debt for the first time since 1991, Bank of America Merrill Lynch index data show. The securities are returning more than twice as much as stocks this year, even after Moody’s Investors Service downgraded 15 of the world’s largest lenders last month, as confidence mounts they can weather a deepening crisis in Europe and a global slowdown.
“If I am a bank bond holder, I am looking at an institution that is going to have more cash, less leverage and a more conservative financial profile,” Mitchell Stapley, chief fixed-income officer at Fifth Third Asset Management in Grand Rapids, Michigan, which oversees about $12 billion in fixed- income assets, said in a telephone interview. “I am less worried about growth prospects than I am about stability.”
Bond investors are targeting debt of financial companies that are yielding 3.45 percent compared with 3.05 percent for industrial bonds in the U.S., Bank of America Merrill Lynch index data show. Bank borrowing costs are down from last year’s high of 5.05 percent on Nov. 30.
“There was a lot of risk premium priced in at the end of the year into the bank space in part because of dislocation due to European problems,” said Ashish Shah, the head of global credit investments at AllianceBernstein LP in New York. “The outperformance of bank bonds is telling you that you were getting paid enough to take greater risk.”
Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. was little changed, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, decreasing 0.3 basis point to a mid-price of 111.2 basis points as of 11:49 a.m. in New York, according to prices compiled by Bloomberg.
The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default 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.
The U.S. two-year interest-rate swap spread, a measure of bond market stress, decreased 1.8 basis points to 23.74 basis points as of 11:48 a.m. in New York. The gauge narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.
Bonds of Sumitomo Mitsui Banking Corp. are the most actively traded dollar-denominated corporate securities by dealers today, with 112 trades of $1 million or more as of 11:50 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The Tokyo-based lender sold $3 billion of debt yesterday in a three- part offering.
The total face value of debt raised by U.S. banks through corporate bonds has fallen to $905 billion from $908 billion at year-end, Bank of America Merrill Lynch index data show. That’s after increasing every year from $34 billion in 1991 through 2011.
New regulations from U.S. Congress and the Basel Committee on Banking Supervision are spurring the biggest banks to pare holdings of corporate bonds to $43.3 billion as of June 27 from a peak of $235 billion in October 2007, according to Federal Reserve data.
Bank of America, JPMorgan and SunTrust Banks Inc. said last month that they were redeeming trust-preferred securities following the Fed’s June 7 release of capital rules being mandated under Dodd-Frank, enacted in 2010.
“As their net debt continues to shrink, their capital ratios continue to climb,” said Michael Plage, a money manager who helps oversee the $397 million Fidelity Corporate Bond Fund from Merrimack, New Hampshire. “There’s been tremendous improvement over the past 18 months or so. Their liquidity metrics continue to improve.”
Deposits of all U.S. banks exceed loans by $1.6 trillion as of June 27, Fed data show. That’s up from less than $1 trillion as of September 2010 as deposits at U.S. banks have climbed by about 12 percent in that period.
Investors are bidding up prices on bank bonds even after Moody’s downgraded 15 lenders and securities firms with global capital markets operations on June 21, citing their “significant exposure to the volatility and risk of outsized losses inherent to capital markets activities.”
The $1.5 billion of 5.8 percent bonds from Lloyds, the partly state-owned U.K. lender, have returned 15.4 percent this year, Bloomberg data show. The notes that mature in 2020 are trading at 107.1 cents, 11 cents more than at year-end, according to Trace data.
Charlotte, North Carolina-based Bank of America’s $2.25 billion of 5.7 percent bonds have risen 12.3 cents to 111.9 cents on the data since Jan. 19, Trace data show.
Spreads on Bank of America bonds have narrowed 242 basis points since year-end to 323 basis points, more than twice the 117-basis-point decline on the broader bank index to 267 basis points.
Bank bond returns this year compare with a 3.8 percent gain on the MSCI All-Country World Banks stock index.
In addition to increasing faith in bank balance sheets, bondholders are expressing optimism that the European fiscal crisis won’t derail global financial markets.
European governments laid the groundwork for possible purchases of Italy’s bonds and fast-tracked aid for Spain’s banks, with finance ministers saying the first 30 billion euros ($37 billion) of 100 billion euros in rescue loans will start flowing to Spanish banks this month.
“There was the Spanish bank recapitalization the first week of June, Greek elections that ended in a favorable outcome and then the Moody’s downgrades which weren’t the worst case scenario,” Plage said. “With reduced uncertainty comes risk- asset rallies.”
The Bank of America Merrill Lynch index of industrial companies from Dallas-based AT&T Inc. to computer-maker Hewlett Packard Co. is poised to underperform banks for the first time since 2006, when returns of 4.2 percent on the index were exceeded by 4.4 percent gains on U.S. bank bonds.
The gap between the relative yields on U.S. bank bonds and the debt issued by industrial companies declined to 81 basis points on July 5, the least since Aug. 3, Bank of America Merrill Lynch Index data show. The difference was at 83 as of yesterday.
“The euro headlines have kept the gap there because of a pervasive sense of dread,” Fifth Third’s Stapley said. “But the longer we go without Europe imploding and as these banks continue to build capital, that gap is going to shrink.”
Thomas Chow, a money manager at Delaware Investments in Philadelphia, predicts that the proportion of bank bonds in the overall investment grade index will diminish over the next few years.
“Banks are trying to portray themselves as better capitalized and thus able to absorb more economic volatility,” he said.
To contact the reporters on this story: Sridhar Natarajan in New York at Snatarajan15@bloomberg.net; Lisa Abramowicz in New York at email@example.com
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