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Bond Investors Not Banking on Stress Tests

Stock markets rallied as most of the large U.S. banks passed the latest round of “stress tests.” But bond investors, perhaps harsher graders than the Fed, were less encouraged by the news.

Investing pros say the tests – which measure how well the banks can survive another downturn – demonstrate that the big banks have come a long way since the crisis. Investors, however, continue to shy away from bank bonds, expressing concerns that a sluggish housing market, risks in Europe and regulatory uncertainty could increase their default risk. Many banks are still writing off mortgage losses and could see more foreclosures down the line, says Wilmer Stith, manager of the $290 million Wilmington Trust Broad Market fund (ARKIX). That threatens their long-term profitability and creates uncertainty for bond investors, says Stith. “We’re not out of the woods,” says Stith.

Yields on bonds issued by financial companies have decreased to an average 2.4 percentage points over five-year Treasurys, down from 3.5 percentage points in November. But that is still far from their long term average of 1.4 percentage points or the 0.7 point spread before the financial crisis, meaning some investors are still holding off, says Anthony Valeri, fixed income strategist for LPL Financial.

Another thing to watch, say experts: the banks recently granted approval to buy back shares and reward shareholders by increasing dividends will have less cash on hand for paying back debt. That chips away at their credit quality and increases risks for bondholders, says Jason Brady, head of taxable fixed income for Thornburg Investment Management. “There would be less margin of safety,” says Brady.

That said, some investors feel comforted by the vote of confidence most large banks got from regulators. The Fed said 18 of the 19 financial firms tested have enough capital to keep lending in a downturn. And the fact that many banks have enough capital to reward shareholders is normally a sign that banks are in good health, says Valeri. Increased comfort among investors could eventually lead to a rally in bank bonds, he says.

Still, some investors will wait before piling back into bank bonds. Stith says he prefers bonds issued by regional banks over those issued by large ones. Their simpler business models of using deposits to make loans makes them less reliant on investors and other markets for funding, he says.  They also shied away from the risky trades some big banks made leading up to the financial crisis, he says.

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