Bonds of financial institutions are returning more than those of industrial firms for the first year since 2005 as banks cut debt amid regulatory scrutiny while companies leverage up to tap record-low borrowing costs.
Bank bonds globally have returned 9.9% in 2012 compared with 6.9% for industrial companies, Bank of America Merrill Lynch index data show. Yields on Citigroup Inc. notes have dropped 1.85 percentage points, compared with a 1.67 percentage point decline for all financial debt, as the lender bailed out by the U.S. in 2008 reduced its long-term debt by about $11.9 billion this year by buying back bonds.
Investors are gaining confidence that banks will be able to repay their obligations amid a simmering fiscal crisis in Europe as the volume of their outstanding debt in a benchmark index shrinks 3.4% over the past four years, compared with a 58% increase in industrial bonds. The extra yield investors demand to own financial-company notes instead of industrials is about the least in a year.
"A significant portion of the rally in credit has been a quiet European front," with the lack of negative news increasing risk appetite, said Scott Kimball, a money manager at Taplin Canida & Habacht LLC, a BMO Financial Group unit that oversees $7.2 billion. While new regulations spurring banks to pare holdings of riskier assets may weigh on earnings, "it will be a positive for credit investors," he said.
Investors are funneling cash into the notes even after Moody's Investors Service downgraded banks on June 21 to an average four levels lower than at the height of the financial crisis. Yields on the debt have dropped to an average 3.16% from as high as 9.1% in March 2009, Bank of America Merrill Lynch index show.
"I do expect U.S. banks/financials to outperform" due to low net issuance, improving fundamentals and decent relative valuations compared with industrials, Mark Kiesel, global head of corporate bond portfolios at Newport Beach, California-based Pacific Investment Management Co., which oversees the world's largest mutual fund, said in an e-mail.
Elsewhere in credit markets, Electricite de France SA, Europe's biggest power generator, and Enel SpA led at least 8.3 billion euros ($10.5 billion) of debt sales in the region's busiest day for issuance since February. General Electric Co., the biggest maker of power-generation equipment with $32 billion of bonds maturing in the rest of 2012, plans to sell three- and 10-year notes in the U.S.
The U.S. two-year interest-rate swap spread, a measure of strain in credit markets, narrowed 0.38 basis point to 16.87 basis points as of 11:32 a.m. in New York. The measure, which shrinks when investors favor assets such as corporate bonds and expands when they seek the perceived safety of government securities, is at the lowest level since April 2011.
The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, was little changed at 101.6 basis points, according to prices compiled by Bloomberg. The index has dropped from a six-month high of 127.5 basis points on June 4.
In London, the Markit iTraxx Europe index, tied to 125 investment-grade companies, fell for the third day, declining 2 to 143.1.
Credit swaps typically fall as investor confidence improves and rise as it deteriorates. The contracts 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.
Bonds of Caracas-based Petroleos de Venezuela SA, or PDVSA, are the most actively traded dollar-denominated corporate securities by dealers today, with 48 trades of $1 million or more as of 11:31 a.m. in New York, according to Trace, the bond- price reporting system of the Financial Industry Regulatory Authority.
GE intends to issue new 10-year securities and additional 1.625% debentures due in July 2015 through its GE Capital unit for general corporate purposes, according to a person familiar with the offering who asked not to be identified because terms aren't set. The deal will be of benchmark size, typically at least $500 million, the person said.
EDF's 2 billion-euro sale of bonds due March 2023 is the first time it tapped capital markets since March and the Paris- based company's biggest deal since January when it raised 2 billion euros from 10-year notes, data compiled by Bloomberg show. Italy's Enel is selling 1 billion euros of bonds due March 2020, the company's first sale in seven months.
Issuers today include luxury German carmaker Daimler with a 750 million-euro 10-year deal, Ireland's Electricity Supply Board, which is raising 600 million euros for five years and Sweden's SKF AB with a 500 million-euro seven-year deal.
Money managers have been emboldened to increase bets on a shrinking supply of financial debt this year after largely holding a smaller percentage than is contained in benchmark indexes in 2009 and 2010, said Kimball of Taplin Canida & Habacht.
After the 2008 credit seizure that triggered more than $2 trillion of losses and writedowns by the world's financial institutions, investors for the first time began demanding more to own the bonds of those firms instead of industrial companies.
Financial-bond yield spreads over government debt soared to as much as 282 basis points more than the same measure for corporates in March 2009, Bank of America Merrill Lynch index data show. Before 2007, investors had always accepted less relative yield to hold financial debt instead of industrials.
The gap, which was 116 basis points a year ago, narrowed to 75 basis points on Aug. 21, the lowest since July 2011, the index data show.
The 3 percentage-point advantage in bank-bond returns this year compares with a 1.5 percentage-point outperformance in 2005, the last time they gained more. From 2006 through 2011, industrial bonds returned 45 percent, while financial debt gained 21 percent, Bank of America Merrill Lynch index data show.
Financial bonds returned 0.9 percentage point more than industrial notes in August, the biggest monthly outperformance since March. UniCredit SpA, Italy's biggest bank, and Banco Santander SA, Spain's biggest lender, helped lead the bond rally after European Central Bank President Mario Draghi vowed to do "whatever it takes" to preserve the euro. German Chancellor Angela Merkel has signaled a softening in her stance toward Draghi's rescue plan for Italy and Spain.
UniCredit's bonds returned an average 3% in August, while Santander debentures gained 2.8 percent. That compares with a 1.1% gain for Bank of America Merrill Lynch's Global Broad Market Financial Index.
"We have seen in the last month a rally driven mainly by Europe," said Dorian Garay, a money manager for a global investment-grade debt fund at ING Investment Management, which oversaw 322 billion euros ($402.7 billion) as of year-end. "A limited amount of supply has kept cash spreads at very tight levels."
While banks have amassed greater reserves to buffer against risk, they remain vulnerable to macroeconomic pressures and still hold non-performing assets left over from the credit crisis, Moody's said in a report today.
Banks are reducing debt as the Dodd-Frank Act's Volcker Rule in the U.S. seeks to limit risk-taking at the biggest financial institutions and after the 27-country Basel Committee on Banking Supervision raised minimum capital requirements in 2010.
The face value of debt issued by financial companies in the Bank of America Merrill Lynch global index dropped to $2.85 trillion through Aug. 31 from $2.95 trillion at the end of August 2008. That compares with an increase in the firm's Global Broad Market Industrial Index to $3.4 trillion from $2.15 trillion during the same period.
Banks are buying back bonds and selling assets while a measure of leverage for U.S. non-financial issuers climbed to pre-crisis levels, largely by borrowing more, according to an Aug. 28 report by Bank of America strategists led by Hans Mikkelsen in New York. Companies with investment-grade ratings had debt of 1.78 times earnings before interest, taxes, depreciation and amortization in the second quarter, up from 1.62 at the end of 2011, the analysts wrote in the report.
Citigroup last week increased an offer to repurchase debt from seven series of notes to $1.65 billion from $675 million, according to an Aug. 29 statement from the New York-based lender.
"These offers reflect Citigroup's continued robust liquidity position and are consistent with its recent liability management initiatives," the bank said.
While Pimco's Kiesel predicted bank bonds would continue to perform well, he said he prefers debt from pipeline and energy companies and borrowers poised to benefit from a recovering housing market.
Home prices in 20 cities climbed in June for the first time since 2010, with the S&P/Case-Shiller index increasing 0.5% from a year earlier, according to an Aug. 28 report.
The U.S. economy expanded more than previously estimated in the second quarter. U.S. gross domestic product increased at a 1.7% annual rate from April through June, up from an initial estimate of 1.5 percent, revised Commerce Department figures showed Aug. 29 in Washington.
The ECB is deliberating over which bonds it will buy as members seek to strengthen financial institutions in the region and lower sovereign borrowing costs. Draghi said on Aug. 2 that the central bank may wade forcefully into bond markets in tandem with Europe's rescue fund, stepping up its crisis response despite the reservations of Germany's Bundesbank.
"People find a lot of comfort in the idea of European central banks doing debt repurchases," Kimball said.
