As U.S. bank profits surge, bond investors, the people who lend money to banks, say they expect the good times to last awhile longer.
Companies such as NationsBank Corp., First Union Corp., and Chase Manhattan Corp. last week reported robust second-quarter earnings based on steady consumer loan growth and rising fee income. The winning streak probably won't end soon because the economy isn't about to stumble, bond investors say.
"Bank bonds have been on a five-year roll since 1991," said Tad Rivelle, who helps manage $2 billion at Hotchkis and Wiley, a Los Angeles-based mutual fund manager. Bank stocks, on the other hand, have taken a pummeling lately.
The Standard & Poor's index of money-center bank stocks is off 1.8% since July 1. Bank bonds, meanwhile, haven't given an inch, and the possibility that the Federal Reserve may not raise bank borrowing rates as quickly or as much as expected may help keep the luster on bonds this year, analysts said.
"Short of a very, very serious and prolonged downturn, banks are pretty fixed as credits," said Ethan Heisler, a bank analyst at Salomon Brothers Inc. "They won't get into too much trouble."
Still, bond investors have a problem: The spreads between yields on corporate bonds and those on comparable Treasuries are narrower than ever, implying lofty prices.
Ten-year bank bonds rated A2 by Moody's Investors Service, for example, recently were priced to yield 67 basis points more than the 10-year Treasury bond. A year before, they had yielded 77 basis points more than Treasuries.
One reason bond investors are still drawn to banks lies in their earnings growth this year, bank analysts said.
"We're seeing some pretty fancy returns," said David Berry, research director at Keefe, Bruyette & Woods Inc. "The industry is really managing pretty well."
Even so, some bond investors and analysts are becoming wary. There are signs the economy is poised to slow this year and next, and that could play havoc with bank bonds.
While many U.S. banks reported robust second-quarter earnings, they also posted rising chargeoffs for consumer loans.
"The further we get into the business cycle, the more marginal the borrowers tend to become," said Mr. Rivelle of Hotchkis & Wiley. "People and corporations are increasing the debt on their balance sheets, and banks are extending credit to weaker borrowers."
The nation's banks are far from facing the sort of losses that confronted them in the 1980s, analysts said. But the best news may be over, and the bonds of some banks may slip on hints of losses, they said.
Consumer loan losses are "a problem for banks but a manageable problem," said Michael Leit, analyst at Prudential Securities Inc. Still, "if you have a negative view on the economy, you might want to selectively sell some bank bonds."
Investors are still willing to buy the bonds because they offer higher yields than Treasuries. But prices would only have to fall a bit for investors possibly to get skittish.
An investor who sold the 10-year Treasury note to buy the 7.5% bonds First Union issued last week would garner an extra 65 basis points in yield. Yet if the bond's price fell in the next six months, widening the yield spread between it and the comparable Treasury, any advantage of the higher yield might be canceled.
If the yield spread widened more than 6 basis points in the next six months, investors would have been better off in Treasuries, according to Bloomberg Financial Markets.
Exactly that sort of calculation led some investors to look at yankee bonds, debt issued in the United States by foreign companies, which offer yields about 15 basis points higher than their domestic cousins' debt.
In Europe and Asia, an economic recovery is only beginning to take hold so that a greater chance exists for gains.
That's put a shine on the debt of banks like Spain's Banco Santander, France's Societe Generale, and Union Bank of Switzerland, said some investors.
"I don't see any reason why the economic environment would cause those banks to face any greater threat than U.S. banks, so it sounds like it would be an attractive trade," said Jan Faller, who helps manage $4 billion in bonds at Pan Agora Asset Management in Boston.
Even U.S. banks could continue to benefit from the last leg of the nation's economic recovery, analysts and investors said. Though losses are increasing and the chance of a recession may grow, the good times may not end anytime soon, they said.
"Concern about losses really hasn't negatively affected the bank bonds," said Andrew Gilligan, bank bond analyst at Bear, Stearns & Co. "In general, bank bonds have held in."