The spread between the debt of industrial companies and commercial banks rated singleA or better is at its tightest level in almost a decade, according to the latest figures from Salomon Brothers.
Not since the mid-1980s, before Third World debt and highly leveraged real estate transactions decimated the industry, have bank bonds traded so near to their industrial peers.
In fact, for the last three months, bank bonds on average have actually traded at a slightly lower yield than industrial bonds, according to preliminary statistics gathered from traders.
The low yields reflect both a demand for bank debt, now that the industry's problems are seen as resolved, and a lack of new bonds being issued by banks, now that they have achieved their capital-raising objectives.
Cheaper Capital Ahead?
"Many of the highly publicized 'potholes' of the 1980s have been addressed, and banks are more credit-sensitive than they have been in many years," said Salomon Brothers bond analyst Katharine Rossow.
On the surface, this would appear to herald an era in which banks can raise capital more cheaply. But bankers note that part of the reason yields have fallen is that banks are already well capitalized. Thus there is little reason to cheer.
It amounts to a kind of a Catch-22, said Boatmen's Bancshares chief financial officer James W. Kienker.
Last year his bank issued $ 100 million of subordinated notes, and the cash has essentially been "warehoused," Mr. Kienker said.
"We have plenty of money," he said, but by issuing new debt, "we would just be warehousing more money."
Only three years ago, mired in tens of billions of dollars of bad loans and saddled with a miserable image, banks traded more than 300 basis points over the 10-year Treasury bond.
Investors perceived them as more risky than similarly rated industrials, which traded at fewer than 150 basis points above the 10-year Treasury.
Typifying the turnaround that has occurred since then, Citicorp, in November of 1991, traded at 300 basis points over the 10-year Treasury. As of last May 9, it traded only 79 points over the 10-year, according to Salomon Brothers - a 74% improvement.
On average, A-1 industrials and A-I banks now trade between only 70 and 80 basis points over the 10-year Treasury.
Improved credit quality and strong capital levels have caused a sharp increase in demand for bank bonds, a bond trader said.
But because there is such a demand for the bonds, the secondary market has been less willing to relinquish their bank bonds, said Merrill Lynch analyst Bill King. Most investors are comfortable simply holding on to the bonds, he said, and as a result there have no major sellers recently.
In tandem with that trend, he continued, there has been a dearth of new issues because banks, in many cases, are overflowing with capital.
Watching for External Factors
While most industry observers do not worry about the yields rising any time soon, a bond trader noted that a wholly unrelated, external event could suddenly cause a sharp rise in the spread.
If a company like Conseco, for example, which is now moving to finance its bid to acquire Kemper, were to suddenly sell off bank debt to raise cash for its acquisition, it could create a drop in bank bond prices, the trader said.
However, the main driving force behind debt quality is credit, and banks are well positioned there, said Merrill Lynch's Mr. King.
"The real threat is you would have to have a credit problem, a few blips," he said. If interest rates were to rise, then prices could suddenly drop, he added.
But the pattern has been for bank bonds to weather interest rate hikes and settle back down after a minor run-up in yields.
Thus, if the Federal Reserve hiked rates this week or next, he said, there would be a slight widening of the spread, but then it would narrow again, according to this trader.
Looking at the Future
Will the era of narrow spreads last forever? The observers say no.
"The credit looks good now, but it wasn't that long ago that things were bad," said Thomas Stone, a bond analyst with Duff & Phelps Credit Rating Co.
If interest rates rise, or nonperforming assets reverse course and begin to creep up as a percentage of loan portfolios, Mr. Stone said, then the margins will likely widen again.
Ms. Rossow said that while banks have made improvements, the industry is still a largely cyclical, highly leveraged one.
"We also believe that the current competitive and regulatory environment places inherent stress on the industry to constantly search for profitable niches that do not violate regulatory limitations on permissible activities," she wrote last month in a report on the issue. "This pressure will continue to lead to periodic over-concentration of risk."
And while the headaches of the past, like the collapse of the thrift industry and the emergence of alternative capital markets, have largely been resolved, she said, new headaches almost surely are lurking just around the corner.
