REFILE-US bank risk back near pre-crisis levels

Wed Dec 19, 2012 3:12pm EST

By John Balassi

Dec 19 (IFR) - Improved fundamentals and a shrinking supply of bonds have compressed US bank risk premiums to their lowest levels since the onset of the credit crisis.

In fact, investment-grade bank spreads are once again close to trading through the spreads on industrials - something that hasn't happened since November 2007.

The FIG sector spread on the Barclays Corporate Index at the open on Wednesday was 151bp, very close to the 133bp spread on the sub-index for industrials.

"As long as we don't plunge headfirst off the fiscal cliff and Europe remains contained - or if nothing out of consensus happens - bank spreads should grind tighter," said a senior Wall Street strategist.

Financials have decidedly outperformed non-financials on an absolute and beta-adjusted basis in 2012, tightening more than 193bp while non-financials have narrowed only 52bp.

As lenders of capital, banks have traditionally been a lower beta sector - that is, less volatile relative to the overall market - because of their funding advantages over borrowers.

When the sovereign debt crisis was in full bloom last year, for example, the 1-year beta for financials was around 2.0x - twice as volatile as the general market.

As conditions have improved since then, however, the FIG sector has moved closer to its natural position as a relatively lower beta piece of the market.

According to research from Morgan Stanley, the 1-year beta for financials will likely fall even further from current levels (1.37x), edging closer to the trend lines of the broader index.

DOWNWARDLY MOBILE

In the current environment, investors have repeatedly shown themselves to be comfortable moving down the credit spectrum this year when it comes to US banks.

The sector's fundamentals have decoupled from Europe's sovereign troubles, and there are signs of improvement in the US residential real-estate market.

Wells Fargo on Tuesday became the first of the six-largest US commercial banks to price a double-digit spread for five-year debt since 2007. The achievement is even more impressive considering that the average rating of the financial index is two notches lower than it was at the beginning of 2007.

At a recent conference sponsored by Goldman Sachs, most banks expressed confidence in their performance on the upcoming bank stress tests, noting that capital levels continued to grow and that credit quality was still improving.

The majority of US banks are at or above their targeted Basel III Tier 1 common ratios and are now at a post-crisis high of 10.75%, while non-performing assets and net charge-offs have continued to fall.

Meanwhile US bank credits are not trading on fundamental value alone. Supply-demand imbalances are providing strong technicals for credit spreads.

While new issuance has been extremely robust in 2012, the net supply of bank bonds has remained negative, with banks allowing a proportion of maturing bonds to roll off without reissuing.

The general deleveraging of banks and the valuation premiums assigned to financial issuers are factors that help explain the relatively muted new issuance in the past two years.

Given high balance sheet liquidity, US banks can afford to be selective and not access the funding market when conditions are challenging.

A recent Barclays Research report said US banks have accumulated $1.7trn in new deposit funding since the first quarter of 2009, pushing down the ratio of less liquid loans versus more stable deposits to a 17-year low.

And while financials have become more conservative with balance-sheet issuance, the record low cost of financing has fueled aggressive leveraging up by industrial companies.

Industrial management teams have been opportunistic in locking in low-term yields to pre-fund future maturities as well as M&A, and to fund shareholder-friendly activities with cheap debt.

At the same time, robust issuance in the industrial sector has limited secondary gains within the space.

"It is tough to move the secondary axis tighter when clients feel like there is consistent new supply coming on the market," said one senior FIG trader.

In terms of sector allocation, industrial new supply represents 62.8% of the total $601.96bn in US-domiciled issuance, while new supply from US banks accounts for just 15.7%, according to Thomson Reuters data - well below its traditional share.

Industrial issuance from US companies enjoyed a strong reception that stands at $327bn for the year on 395 issuers, or a 35.6% increase over last year's record total. Financial sector issuance for US banks, at $95.5bn on 123 issuers, showed a 9.9% decrease over last's year's $105bn in supply.

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