Bank Bonds Offer Value As Financial Rules' Volatility Lessens

12th Jul 2010 19:06

By Chris Dieterich Of DOW JONES NEWSWIRES NEW YORK (Dow Jones)--Prices for bonds issued by U.S. banks and other financial institutions are poised to rise despite the fact that the U.S. Senate could pass landmark financial-overhaul legislation as soon as this week, investors and analysts said. That's because worried investors went too far this spring in selling off financial bonds over fears about how far Washington would go in overhauling financial-market regulations in the wake of the credit crisis. Now that the rules look less onerous than many feared, some investors see value in financial-bond yields that are higher than other sectors and remain elevated by historical standards. "They have been through a debacle," James Lee, senior fixed-income analyst at Calvert Asset Management, said of financial bonds. "They still offer good value in the context that the worst is over." Risk premiums, or spreads, for bonds in the banking sector are wider than their historical average and higher than investment-grade debt from all other industries. The spread--the extra yield investors demand to hold the banking-sector bonds--was 2.37 percentage points higher than Treasurys on July 9, according to Barclays Capital, and 0.21 percentage points higher than the banking sector's trailing five-year average. Banking-sector spreads are a full 63 basis points, or 0.63 percentage points, wider than the Barclays investment-grade U.S. Credit Index. Since yields move inversely to bond prices, wider yields mean bonds are relatively cheap. As relative prices rise, yield spreads will narrow. With details of the financial regulation mostly known, these bonds are much less volatile than a few months ago, said Dan Mead, a managing director in Investment Grade syndicate who specializes in financial debt at Bank of America Merrill Lynch. "After significant weakening through the spring we're seeing bank spreads tighten again," he said. Mead said Bank of America foresees financial spreads narrowing over the next few months, in part because investors will likely see less in the way of investment-grade supply. Bank of America Merrill Lynch recently lowered its forecast for 2010 U.S.-marketed, high-grade debt by 12.5% to $700 billion. Risk premiums have already started to tighten for many big banks. Spreads for the most heavily traded notes issued by Goldman Sachs (GS), Morgan Stanley (MS), Bank of America Corp. (BAC), J.P. Morgan Chase & Co. (JPM) and Citigroup (C) have sunk between 0.10 and 0.34 percentage points over Treasurys since the start of July, according to MarketAxess. "Spreads over Treasurys are likely to continue to tighten, so yeah, I think [bank bonds] are attractive," Calvert's Lee said. Investment bank Goldman Sachs' 5.375% notes due March 2020 were trading at 220 basis points--2.2 percentage points--over comparable Treasurys on Monday; that was 83 basis points wider than on April 15. Citigroup's 8.5% May 2019 notes traded 244 basis points over Treasurys, 61 basis points higher than a five-year low on April 15. Bond prices fell and yields surged in the investment-grade banking sector in April after the Securities and Exchange Commission charged Goldman Sachs with defrauding investors by betting against the housing market. Investors worried that the case would encourage stricter regulations. Average spreads for the investment-grade banking sector rose from 1.66 percentage points over Treasurys April 16, the day the SEC filed charges against Goldman, to 2.58 percentage points June 9--the highest since December 2009, according to Barclays Capital. The charges fed nagging uncertainty about how deep the new banking rules might cut into profits for the largest U.S. banks, and traders responded by selling bank debt, said Jacob Habibi, investment-grade credit analyst at Invesco Fixed Income. "The market tends to react to this kind of thing by selling off beforehand, when there's a great degree of uncertainty," Habibi said. Anxious investors, driven by fears about Goldman Sachs' near-term default, inverted its credit-default swaps curve between early May until the first week of June, meaning that it cost more to insure against the investment bank's short-term default than against default over the long term. That was a powerful sign of credit market distress directly attributable to fears associated with the pending legislation, said Michael Johnson, chief market strategist at M.S. Howells & Co. Much of the anxiety has dissipated now that the bill is widely viewed as less burdensome than many on Wall Street originally feared, but yields for high-grade bank bonds are still relatively high. "Some [bank bonds] trade at pretty attractive spreads...I think that some of the high-grade, larger, money-center banks offer very compelling value," said Derrick Wulf, portfolio manager at Dwight Asset Management in Burlington, Vt. Still, the euro-zone bank funding situation and lingering uncertainty about the firmness of the U.S. economic recovery means bank bonds still carry some risk. "I see more value in the financial sector than other sectors, but performance still will be driven by broader macroeconomic factors," Invesco's Habibi said. "There's not going to be a lot of value there if we go into a double-dip." -By Chris Dieterich, Dow Jones Newswires; 212-416-2611; [email protected] -0- (MORE TO FOLLOW) Dow Jones Newswires July 12, 2010 14:06 ET (18:06 GMT)