Article / 30 August 2017 at 10:00 GMT

Weekly Bond Update: Investors remain wary of financials — #SaxoStrats

Fixed income Specialist / Saxo Bank
Denmark
  • Rules designed to make banking more resilient have been enforced
  • Banks have been investigated, strengthened and stress tested
  • Incentives for bankers to take on risky activities have been removed
  • But investors prefer high-grade corporate bonds to financial sector bonds
  • Fed's Yellen says deregulation threatens the resilience of the financial system

By Althea Spinozzi

As we get closer to the 10th anniversary of the financial crisis, we cannot help wondering whether we are living in a more solid market, or if the financial institutions that we trust will fail us again.

The reality is that for banking, a lot of things have changed since the great recession. Regulators have scrutinised many aspects of this sector, with the aim of imposing rules that would make the financial market more resilient to volatility and stress situations. Higher capital requirements have been imposed to ensure that banks do not take excess leverage and become insolvent. Bank liquidity requirements have been increased and compliance checks improved, and stress-tests have been carried out to ensure that banks will remain solvent during crises.


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Financials may offer better returns than corporates, but investors need to do some cherry picking between the alternatives to find their desired balance between risk and return. Photo: Shutterstock

Not content with the results, and as scandals such as the Libor fixing are made public, regulators have looked deeper into the management of banks, and imposed further restrictions on bankers' pay and bonuses. The aim is that bankers should have no incentive to take on risky activities, thereby guaranteeing an overall sounder financial environment.

We are now living in a world where banks are sounder and better regulated than before, yet spreads in the financials space are wider than they were before the financial crisis hit, so why are some investors hesitant to put their money into this sector?

Yields on 10-year US and European financial and corporate bonds

US and European 10-y corporate and financial bond yields
Source: Bloomberg 

To understand whether there is potential for returns in the financial bond market, it is important to compare yields with those in the overall corporate bond market. The above graph displays 10-year yields for US and European investment-grade financial bonds together with the average 10- year yield in the investment-grade corporates. It is clear that during the past year, yields in the financial sector – both in Europe and in the US – have been consistently higher than yields in the overall corporate space, and that the movement of the two has mostly been aligned.

Well-known and established names in the financial sectors, such as JP Morgan, Barclays and Unicredit, pay well above treasuries. For example, if we take senior unsecured issues in USD of these banks, we can see that Citi at 3.887%, 2028, is priced 140 basis points above Treasuries, paying a 3.5% yield; Barclays at 4%, 2026, pays 145 bps above Treasuries, paying 3.8% yield; and Unicredit at 4.625% for 2027 is priced 180 bps above Treasuries, paying 3.9% yield.

Suspicious minds

All of these are investment-grade, meaning that they are far from default. But investors still look at the financial sector with suspicion and would rather put their money in a high-grade corporate in the consumer sector.

The reason spreads in the financial sector are higher lies in the fact that even though tougher regulations and requirements have been implemented for banks, many institutions have yet to prove that they are actually solid. In Europe, many periphery banks still struggle with bad loan books, and a great part of their profits go towards writing off bad debt. The most affected countries are in Italy, Spain and Portugal, where many small and big banks are still dealing with the burden of non-performing loans.

The big correction in yield in the European financial from January to March 2016 that is shown in the above table reflects the perceived risk coming from the periphery. However, at the same time, in these countries it is still possible to find solid names, such as Banco Santander, Banco Bilbao Vizcaya Argentaria (BBVA) and Intesa Sanpaolo, that could diversify your portfolio and pay interesting yields.

In addition, many banks still rely in great part on wholesale funding to carry on with their lending activities. Wholesale lending represents an opportunity for banks when the yield curve is normal. But as soon as the yield curve is inverted or flat, wholesale lending can become a problem as the spread between deposit costs and bond yields becomes smaller and smaller.

The threat of deregulation

US president Donald Trump is adamant that he will implement deregulation of the financial market. Trump's proposed changes would allow the largest lenders to take on more deposits and to move a big part of their investments into higher-yielding treasuries, and issue less debt. Trump's plan implies that banks will not need to finance their operations with more capital, making the financial sector vulnerable, as it was before 2008. The latest speech made against such deregulation came from US Federal Reserve chief Janet Yellen last Friday at the Fed's Jackson Hole summit. Yellen indeed warned against deregulation, as it would put at stake the resilience of the financial system.

Trump's deregulation policy may represent an opportunity for the bigger American banks, as they would be freer to decide how to allocate capital. But in the long run, this may cause imbalances that may cause further volatility in the financial sector or the economy as a whole.

To sum up, the financial sector has been made more solid by regulations enforced in the past 10 years. And even if yields in the financial sector are wider, there is more control over the health of financial institutions. Now that Trump is considering deregulating, US banks may benefit from his policy changes. But investors should assess what investment strategy works best for their needs.

Solid non-US banks

Long-term conservative investors that are not enchanted by Trump's promises may look with interest at solid names outside the US. Canadian, Nordic and Australian banks benefit from good loan books even though they have high wholesale funding bank ratios. To give an example, Toronto-Dominion's senior unsecured debt is rated AA- (S&P) and offers a yield of 2%, which is abiyt 48 basis point above Treasuries for a four-year maturity. Similarly, Nordea's senior unsecured debt (AA- according to S&P) with 2020 maturity offers a 1.9% yield, which is 50 basis point above Treasuries.

The bottom line is that financials may provide better returns than corporates. But cherry picking is essential to obtain the desired balance between risk and returns.

Bank
 Regulations have generally helped make the financial sector 
more solid in the past 10 years. Photo: Shutterstock


– Edited by Robert Ryan

Althea Spinozzi is a sales trader at Saxo Bank

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