To the Federal Reserve, the Federal Deposit Insurance Corporation, the Bank for International Settlements, and the regulators rewriting the rules of finance to make the banking system safer, goes a heartfelt “thank you” from investors in US bank bonds.
In part because of the efforts of these authorities, bank debt has become one of the hottest investments in fixed income.
Bonds sold by banks are trading at their nearest levels to risk-free US government debt since 2007. They are also now more expensive than bonds sold by industrial companies, which had not been the case since the financial crisis.
The average US bank bond is now yielding 2.14 per cent, according to a Barclays index. That compares to 2.33 per cent at the beginning of the year and 3.61 per cent this time last year.
Total returns are impressive, with bank debt outperforming most investment-grade securities in the US corporate bond market over the past 12 months and this year to date.
A wave of credit downgrades by Moody’s, a near-financial system meltdown in the eurozone and a batch of lacklustre results from the biggest banks have failed to dim the ardour of bond buyers.
“As far as increased regulation and oversight goes, bank investors should be elated,” says Michael Mullaney, a fund manager at Fiduciary Trust.
“The push in Washington to strengthen banks’ balance sheets may ultimately help prevent another financial calamity. Add to that better fundamentals for the US economy and you have a compelling story.”
The regulatory push for banks to hold more capital to absorb losses and more liquidity to withstand a loss of confidence may limit growth – potentially hurting share prices – but for most bond investors it means safety.
Total return on bank debt for the past 12 months is 11.1 per cent; year to date it is 1.75 per cent compared with 1.05 per cent on corporate bonds as a whole. The rally has sent spreads on bank bonds to 1.3 percentage points over Treasury benchmarks, the lowest since October 2007, according to Barclays indices.
Despite the spread tightening, US bank debt average yields still represent an attractive pick-up over record low Treasury yields.
Jeffery Elswick, director of fixed income at Frost Investment Advisors, says it is not all upside for bondholders, however, if it means banks have fewer profits to cover bond payments in the future.
“To the extent that any company is safer, we love that from a bondholder perspective. Say a regulator tells Citigroup it can’t pay out a dividend, fantastic. But what is the long-term underlying prospect for a company?
“We have more conversations about where Goldman Sachs and Morgan Stanley will be from a business perspective, with so much regulation both in the US and the G20 and with certain regulators and politicians trying to go back to the Glass-Steagall era [when retail and investment banking were separate].”
Some of the nation’s largest banks, including JPMorgan Chase, Wells Fargo, Bank of America, Morgan Stanley and Citigroup, are taking advantage of investor enthusiasm to sell debt at the new lower borrowing costs.
But, flush with deposits and tied by new regulations, the need for US banks to increase their overall debt levels in coming months may be capped. That in turn increases the value of the available bonds.
“Debt sales are picking up from two or three years ago. But with the new rules in place, they won’t explode,” says Mr Mullaney. “There’s a scarcity value in some of these bonds.”
An open question is how much of the enthusiasm for the big US banks rests on a belief that they will always be bailed out in a crisis, so that bondholders always get paid.
Rating agencies continue to give points for an implicit government guarantee when they assess the creditworthiness of the big US banks, although they have warned that this could soon end when the Dodd-Frank Wall Street reforms are fully implemented. Those reforms call for a mechanism to wind down failing banks in an orderly fashion, spreading losses across shareholders and bond investors instead of the taxpayer.
David Prothro is a manager of the Fidelity Corporate Bond Fund. When asked if he believes he could ever lose money on a JPMorgan bond, his response is preceded by a pause. “The answer is ‘yes’,” he says, eventually, “but would it be too risky and too complex to test forcing losses on a bondholder? There is infrastructure in place and there is political pressure, but the question is whether the government would trigger it or not, and I don’t know the answer.”
Mr Elswick at Frost Investment says the “too big to fail” question is a diminishing part of his investment calculus.
“The further we are away from the crisis, the less likely it is the government will bail a bank out, so we are giving it less and less credit over time.”
If investors do believe big banks remain “too big to fail”, spreads could tighten further, as bank bonds might logically be as safe as Treasuries. That would require an even bigger “thank you” to regulators.
For now, fund managers are hailing the new financial regime for making banks, not too big to fail, simply much less likely to.