Bank Bonds Losing Stigma

Financial firms’ earnings reassure investors.

Investors are accepting the smallest yield premiums on bank bonds relative to industrial companies in a year as earnings surpass estimates at lenders from Bank of America Corp. to Citigroup Inc.

Relative yields on U.S. financial debt have dropped to 73 basis points more than those of industrial companies in the U.S., from 105 basis points at the start of June and the least since Aug. 2, Bank of America Merrill Lynch index data show. The bonds are on pace to produce the best monthly returns since January, gaining 2 percent through yesterday.

Early readings of second-quarter bank earnings are providing comfort that financial companies worldwide are withstanding Europe’s sovereign debt crisis after spending four years shoring up balance sheets and almost doubling capital cushions that protect lenders from losses. In Europe, the gap between yields on financial institutions and other companies narrowed to an 11-month low of 108 basis points on June 30.

“People went into earnings season a little bit skeptical of financials, and the fact they produced good earnings has been a bit of a relief,” Anthony Valeri, a market strategist in San Diego at LPL Financial, which oversees $350 billion, said in a telephone interview. “That’s been a catalyst to cause investors to take advantage of these cheap valuations at a time when there are still lingering concerns about growth, which are probably weighing more on industrials right now.”

Yields on financial-company bonds in the U.S. rose to 305 basis points, or 3.05 percentage points, more than Treasuries with similar maturities in June amid concerns the crisis in Europe would infect balance sheets globally. Moody’s Investors Service downgraded 15 of the world’s largest lenders on June 21, citing their “significant exposure to the volatility and risk of outsized losses inherent to capital markets activities.”

U.S. financial-company bond spreads have narrowed 114 basis points this year to 250 basis points, index data show. That compares with a 29 basis-point drop during the same period to 177 for the dollar-denominated bonds of companies from retailer Wal-Mart Stores Inc. to Anheuser-Busch InBev NV, the maker of Budweiser and Stella Artois.

Banks’ “balance sheets are not as leveraged, and the business models are becoming less complex,” said Jon Duensing, the Boulder, Colorado-based head of corporate credit at money manager Smith Breeden Associates. “That can be an attractive combination for debt investors when considering the likelihood of repayment.”


EBay Bonds

Elsewhere in credit markets, EBay Inc. plans to sell bonds for the first time since 2010 with a four-part benchmark offering. Party City Corp. was said to cut the interest rate on a $1.125 billion covenant-lite term loan backing its buyout by Thomas H. Lee Partners LP. A benchmark gauge of corporate credit risk in the U.S. fell for a third day.

The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against corporate debt losses or to speculate on creditworthiness, decreased 0.5 basis point to a mid-price of 107.8 basis points as of 11:58 a.m. in New York, according to prices compiled by Bloomberg. That’s the lowest since July 3.

In London, the Markit iTraxx Europe Index of credit-default swaps tied to 125 investment-grade companies fell 1 basis point to a more than two-week low of 161.5.

The Markit iTraxx SovX Western Europe Index linked to 15 governments from Germany to Italy fell 1.6 basis points to 261.2, holding near the lowest level since the latest series of the gauge started trading in March.

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.

The U.S. two-year interest-rate swap spread, a measure of debt-market stress, fell 0.44 basis point to 23.25. The gauge, which has climbed from an 11-month low of 22.5 on July 12, narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

Bonds of Smithfield Foods Inc. were the most actively traded dollar-denominated corporate securities by dealers today, with 83 trades of $1 million or more as of 12 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.


Pork Bonds

Smithfield, the largest U.S. pork processor, yesterday sold $1 billion of bonds in its first offering in more than three years after increasing the size of the deal by more than half.

EBay, the world’s largest Internet marketplace is issuing three-, five-, 10- and 30-year debt for general corporate purposes, the San Jose, California-based company said today in a regulatory filing.

The bonds may be rated A2 by Moody’s, the sixth level of investment grade, and an equivalent A by Standard & Poor’s, according to a person familiar with the offering who asked not to be identified because terms aren’t set. Benchmark typically means at least $500 million.

Party City’s seven-year loan was increased to $1.125 billion from $1.05 billion, and the largest U.S. party-supplies retailer will now pay interest at 4.5 percentage points more than the London interbank offered rate, compared with a range of 5 percentage points to 5.25 percentage points, according to a person with knowledge of the transaction who asked not to be identified because the terms are private. The minimum on the benchmark will remain at 1.25 percent.

Financial bonds globally are trading at an average 105.7 cents on the dollar, the highest price since October 2010, Bank of America Merrill Lynch index data show. That compares with a record 113.7 cents for industrial bonds.

Spreads on European financial bonds have narrowed 128 to 287 this year, compared with a decline of 30 to 171 for non-financial companies in the region.

Bank of America bond spreads have declined 270 basis points to 295 this year through yesterday, and Citigroup spreads have narrowed 135 basis points to 267, Bank of America Merrill Lynch data show.

Companies from Goldman Sachs to American Express Co. in the S&P 500 Financials index reported an average $4.54 per share of second-quarter earnings through yesterday, compared with analyst estimates of $4.18 a share, Bloomberg data show.


No Surprises

The ratings cuts by Moody’s last month were widely anticipated, so the companies’ bonds have since rallied with the possibility of even greater downgrades removed, Smith Breeden’s Duensing said. As regulatory changes push banks to lower their debt burdens and shift their businesses to lower-risk activities to comply with new capital rules, the debt is more attractive to investors, he said.

At the same time, a slowdown in the global economy is beginning to weigh on industrial companies’ earnings. Firms in the S&P 500 Industrials Sector Index have reported an average of $5.56 a share, compared with an estimate of $6.09, Bloomberg data show.

The bank earnings have been positive for credit investors because “capital levels remain very strong, credit loss trends are improving and there have not been new negative surprises on legal/regulatory issues,” JPMorgan strategists led by Eric Beinstein said in a July 18 research note.

Bank of America, based in Charlotte, North Carolina, reported a second-quarter profit on July 18 as losses in real estate narrowed and the company reduced allowances for losses from bad loans. Shares of Goldman Sachs rose July 17 after it reported the lowest first-half revenue and earnings in seven years. Citigroup, the third-biggest U.S. bank, reported second-quarter profit on July 16 that beat analysts’ estimates on revenue from advising on mergers, corporate lending and underwriting stocks and bonds.

Investors also are chasing a smaller pool of new financial-company bonds, further bolstering prices, the JPMorgan strategists wrote. Banks haven’t issued bonds after reporting earnings this quarter as they have historically, they said, “likely because bank spreads remain relatively wide and banks remain very liquid so their need for funding is limited.”

The face value of U.S. bank bonds in a Bank of America Merrill Lynch index has declined to $905 billion through June 30 from a peak of $947 billion in July 2011. That figure increased every year through 2011, from $34 billion in 1991.

“Valuations do not look stretched and financials are benefitting from reporting earlier than non-financials and from investors’ current view that European risk factors have declined,” the JPMorgan strategists wrote.



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