The mighty fallen
Once seen as the epitome of a sure thing, banks have experienced a startling fall from grace. Viewed with suspicion and scorned by investors, they face a long road back to favour. But while they are unlikely to ever regain their former lustre, they can aspire to be boring, safe utilities.
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The regulatory environment is forcing banks to shrink their balance sheets. But from a price perspective, the impact of regulation has probably been largely factored in already, said one DCM banker. Stocks have been punished for regulatory ambiguity far more than bonds have, he said, because regulation is seen to be more of a threat to profitability than solvency.
Having said that, banks have not escaped unscathed in the debt markets. The financial crisis has been transformational in terms of the composition of the crossover sector, with around 15% of such credits now financial institutions. High-yield fund managers have had to learn more about the financial sector, which they could once blithely ignore, if they want to properly analyse the bonds they have to own.
With large issuers and banks like Bank of America Merrill Lynch, rated Triple B, hovering one notch above the sub-investment grade universe, managers must be prepared for any ratings action that could affect the index, and therefore their own portfolios.
“Investors need to be ready to adjust and react,” said Tanneguy de Carne, head of non-investment grade capital markets at Societe Generale. “Nobody knows what will happen in the financial sector but there has been a transformation and the trend is downwards. Even some well capitalised financial institutions stand on the brink of a downgrade that could see them become non-investment grade.”
There are variations even within the US FIG space. Morgan Stanley trades wide relative to its peers and is more volatile. As a whole, investors are more discerning than ever before and are looking more closely at financial institutions on a case-by-case basis, rather than taking a broad, top down view on the FIG sector as a whole.
With liquidity being such a major issue for banks, falling out of the investment-grade universe is much more damaging for them than for corporates. A bank’s business model hardly looks workable if a corporate can borrow more cheaply from the bond markets than a bank can. And the experiences of 2008 demonstrate what happens to financial institutions which do not command trust from their peers or their clients.
Bank of America has said it would not issue debt again in 2012, following its activity in the first half of the year, and it could be out of the market for longer still, with one banker suggesting it may not make another appearance for up to three years. Citigroup also said it expected to issue at the low end of the forecast range.
Clearly this reflects the disappearance of appetite for bank credit, resulting from their loss of safe-haven status. Having said that, US banks may be in better shape than their European counterparts, said Jonny Fine, head of US investment-grade debt syndicate at Goldman Sachs.
US banks at least enjoy the luxury of an aggregate loan-to-deposit ratio of approximately 80%, so they have excess liquidity, and therefore have no need to finance their day to day lending activities in the wholesale markets. For US banks therefore, visits to the wholesale markets are to finance their broker dealer activities.
Many European banks, by contrast, have loan-to-deposit ratios often at 120% or higher, though these levels are inching down, meaning they rely on the wholesale markets partially to finance the assets they hold, said Fine. This adds a layer of cost on to their lending activities, or erodes the returns they generate, he said.
Return to normality
Financials traded cheaply relative to corporates in the robust, pre-crisis days, when FIG issuance represented around 60%–70% of overall issuance volume in the US. But as the crisis has taken hold, spreads for FIG have widened, though with issuance levels expected to drop considerably over the coming year and beyond there may be a return to something closer to the longer-term normal relationship between the two.
“Banks were previously seen as a safe haven but now they are viewed as just a different and free standing set of risks,” said Fine. “They are no longer seen as a safe-haven proxy for government risk.”
Because they are so actively traded, FIG bonds have a high degree of beta, underperforming the index in bear markets but outperforming in bull markets.
Bank bonds might soon start to see a contrarian bid, as investors seek to time the market and ride bank bonds up in a rally, suggested one DCM banker. “It is probably a good time to buy bank bonds,” he said. “Earnings will be constrained and stable for the foreseeable future, while banks are better capitalised. Bank bonds certainly look more attractive than bank equities.”
In the longer term, banks could eventually trade tighter again. As new regulations take effect and restore confidence in the sector, and regular stress tests provide more transparency, banks could come to be seen more like utilities, making the sector seem super safe again, said Fine. But there was little prospect of them being viewed as the kind of risk-free bets they were before the collapse of Lehman, he added.