Bank bonds are rallying, supported by debt upgrades, strong earnings, and a scarcity of new sues.

Yield spreads to Treasury securities on banks' 10-year subordinated debt have come in by two to five basis points in the last week.

In addition, the average yield read of the Keefe, Bruyette & Woods bank bond index has tightened by four basis points this month, to 80 basis points over the 10-year U.S. Treasury note on July 16, the tightest spread ever, said Brian Furbish, a Keefe vice president.

Forces Work to Tighten Spreads

"The expectations that earnings would be strong, that asset quality would improve, and that the broad trend in ratings would be toward upgrades have all worked to tighten spreads," said Allerton Smith, bank debt analyst with First Boston Corp.

In addition, there has been a lack of new supply of bonds while demand remains strong, said Michael Leit, bond analyst with Bear, Steams & Co.

Citicorp and Shawmut National Corp. have been the star performers this month.

The spread on Citicorp's 10-year subordinated debt has tightened 15 basis points since July 1 to 95 basis points, said Catharine R. Brady, analyst with Salomon Brothers.

Moody's Investors Service last week upgraded Citicorp's subordinated debt to Baa2 from Baa3, senior debt to Baa1 from Baa2, and cumulative preferred stock to an investment grade Baa2 from a junk Ba1 rating.

Ms. Brady noted that the upgrades surprised the market because Citicorp's long-term debt had not been on review for upgrade.

"I think in general the market had not expected the debt upgrade that soon, which is why the bonds moved," she said.

Shawmut subordinated debt tightened to 112 basis points from 120 at the start of the month, according to First Boston.

Ms. Brady said the bank's bonds rallied on news of its successful bulk sale of real estate assets and reduction of nonperforming assets.

The bank in the second quarter completed the sale of two packages of real estate assets with a carrying value of $309.8 million.

Split on Strategy

Analysts differ over whether spreads are so tight that investors should trim their holdings.

"We've talked to a number of investors lately, and no one's selling, but everyone questions whether [spreads] can get any tighter," said William King, analyst with Merrill Lynch & Co. "One reason the selloff hasn't happened is that investors don't have that many alternatives in terms of spread over Treasuries that bank bonds provide."

Bear Steams has been recommending a slight underweighting of the bank sector since mid-June because of the "all-time tightness in spreads," Mr. Leit said.

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