Bank debt has become so pricey that at least one corporate bond team is urging investors to buy industrial bonds instead.
Industrial bonds have underperformed bank issues in the last two months and are bargains, according to bank bond analyst Scott O'Donnell and corporate bond strategist John Works of J.P. Morgan Securities Inc. By contrast, they said, bank bond prices carry little upside potential for the rest of the year.
The action taken by the J.P. Morgan team suggests the recent good times for major bank bonds are coming to an end.
"We would never urge clients to abandon bank bonds completely, because they are good, strong core holdings," said Mr. O'Donnell. However, "we remain concerned about the underlying trends" that could impact the banking sector "and therefore maintain a cautious outlook."
The most notable trend is that bank bonds generally, in a huge market turnaround this year, have outperformed-and thus no longer offer attractive prices when compared to-industrial company bonds.
According to a the J.P. Morgan report, bank debt traded as much as 10 basis points cheaper than industrial debt in January (see chart). But that differential has narrowed to "virtually zero," in August, Mr. O'Donnell said.
"While investors should tread lightly in this sector, we think the recent widening has created opportunities to trade out of money-center banks and into selected industrial core holdings," Mr. O'Donnell and Mr. Works said in the report.
The team also is encouraging investors to trade out of banks and into insurance industry bonds because of consolidation in that sector.
Industrial debt has taken a beating this year as the financial turmoil in Asia has deepened, weakening corporate earnings. In the last six weeks, industrial bond spreads-that is, the difference between the yields of Treasuries and corporate bonds-have widened by as much as 7 basis points.
Meanwhile, investors swarmed into bank issues because of their strong ratings and earnings. Banks have also looked attractive because of the consolidation wave, which often creates stronger and better-rated financial institutions.
Yet banks could be in store for a bumpier ride in the latter part of the year, Mr. O'Donnell said.
Although banks have produced strong earnings, the weakness in Asian economies is likely to take its toll, he said. A flattening yield curve- where the yields of varying Treasury maturities converge-also makes it more difficult for financial institutions to make money.
Last quarter's performance reflected solid growth to overcome "a significant decline in lending margins, slower productivity gains and higher provisions for loan losses," Mr. O'Donnell said. "With the domestic economy likely to soften, we believe these negative factors could assert themselves and cause credit fundamentals to weaken modestly."
Another bank bond analyst, Eric J. Grubelich of Keefe, Bruyette & Woods Inc. said it is much too early to divine whether the Asia trouble will severely effect money-centers or banks.
"Many of these banks have suffered headline risk," Mr. Grubelich said. "The banks will be impacted by some degree, but it will not be devastating.
"At the same time, I can't be a raging bull on money-center bonds until the problems overseas settle down," he said, "or until I make sure the light at the end of the proverbial tunnel is not a freight train of bad loans."
Meanwhile the pace of debt issuance from banks is speeding up, according to Securities Data Co.
So far in 1998, banks have issued $223.8 billion of debt, compared with $155.1 billion from Jan. 2 to Aug. 10, 1997, and $229.4 billion for all of last year.
