Oxstones Investment Club™Central Banks have made it clear that record-low interest rates are here to stay. Reputable Government bonds are offering historically low yields (1.45% on 10-year US treasury bonds) and equity markets remain highly dependent on the actions of policy-makers, a consequence of which is forecast by Barclays to be a sizeable increase in short-term volatility.
Mindful of the risks associated with such an environment, where can investors turn for reasonable gains? It would take a brave man to take a gamble on Spanish Government debt, with 5-year yields currently at 6.88%, the global economic slowdown is impacting on industrial companies’ earnings, and emerging markets remain commodity-dependent and susceptible to changes in risk appetites.
A possible answer, however, may lie in dollar-denominated bank bonds, currently offering their lowest premiums in a year relative to industrial companies.
In response to tighter regulations from the Basel Committee on Banking Supervision, and the Dodd-Frank Act, and as a result of the ever closer scrutiny of their activities, banks have gradually sought to reduce debt levels and increase capital reserves this year. Following damaging headlines including the need for recapitalisation of Spanish banks and extensive downgrades by Moody’s in June, this comes as welcome news to those seeking encouragement that stuttering global economic growth and the obvious risks faced by developed economies can be negotiated. This notion has helped drive bank bonds to returns outperforming all other industries. As Mitchell Stapley of Fifth Third Asset Management in a recent interview with Bloomberg put it:
“If I am a bank bond holder, I am looking at an institution that is going to have more cash, less leverage and a more conservative financial profile. I am less worried about growth prospects than I am about stability.”
Further optimism can be taken from plans to reduce expenses at many of the largest American institutions. Bank of America is set to slash its annual expenses by $3bn, primarily from its investment banking, wealth management and trading divisions, and Goldman Sachs is planning reductions of $500m this year.
This increased confidence is reflected by the fall in the cost of insuring against corporate debt. Despite Friday’s 2.6 bp rise in the Markit CDX North America Investment Grade Index, used as a benchmark indicator of the creditworthiness of 125 institutions, the index, at 110.7, is still down over 70 bps from 111.46 on July 11.
Returns on bank bonds are sufficiently high to justify the risks they incur; risks emphasised by the 4.5% fall in first quarter revenue of the five largest US investment banks. However, principal protected bank notes have pared returns due to lower interest rates (1.1% for the 5-year swap rate), leading to a notable increase in non-principal protected notes linked to indices. In contrast to interest rate linked notes which have seen an 18% fall in sales this year, notes linked to the S&P 500, with a YTD gain currently in the region of 8.3%, have surged.
Linking a security to such a well-known gauge simplifies them, which in turn, due to simplified pay-off structures, makes for a far more attractive investment. Combined with issuers better equipped to cope with economic instability through higher capital reserves and lower debt levels, the strong performance of dollar-denominated bank bonds thus far in 2012 may yet continue.
Tags: alternative investments, bank bonds, bank bonds linked to indices, Banks, banks reducing leverage, basel III, dollar denominated bank debt, higher capital requirements, income investments, yield income