Bank bonds need more than Fed test for all clear

March 15 (Bloomberg) -- The biggest U.S. banks will need more than the Federal Reserve’s stamp of approval before they receive an all-clear signal from the bond market.

While relative yields on their bonds narrowed to 265 basis points, the lowest since August, that’s almost 1 percentage point above last year’s low of 173 in April, according to Bank of America Merrill Lynch index data. The gap between spreads on industrial and financial debt has more than doubled from a year ago and credit-default swaps on the six-biggest U.S. banks are 83 basis points higher than last April.

Fixed-income investors are showing they’re not convinced the worst is over from Europe’s sovereign-debt crisis and litigation from faulty mortgages issued during the housing boom, even after the Fed said 15 of the 19 biggest U.S. banks could maintain adequate capital levels in a recession scenario. Bondholders also remain concerned that increased regulations and a slow economic recovery may diminish banks’ profitability.

“It was a positive step, but there’s still risk factors that sit on the table,” Scott MacDonald, head of research at MC Asset Management Holdings LLC, said in a telephone interview from Stamford, Connecticut. “You still have some degree of cautions as to the financial sector vis-à-vis industrials.”

‘Dominoes Fell’

Even as Moody’s Investors Service says financial companies deriving profits from trading and market-making will likely be cut this year, bank bonds have gained 4.7 percent since year- end, on pace for the best quarter since the three months ended September 2010, Bank of America Merrill Lynch index data show. That compares with industrial debt returns of 0.6 percent. In 2011, a 1.7 percent gain for financial securities’ fell short of 9.9 percent on industrials.

“All these dominoes fell between March of last year and March of this year,” said Jody Lurie, a corporate credit analyst at Janney Montgomery Scott LLC, citing the earthquake in Japan, debate over the U.S. debt ceiling and Greece’s worsening debt crisis. “During that time period, banks took center stage in terms of investors’ anxieties.”

Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. declined for a seventh day, with the Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, dropping 0.9 basis point to a mid-price of 90 basis points as of 11 a.m. in New York, according to Markit Group Ltd. That’s the lowest level on an intra-day basis since July 5.

Bondholder Protection

The index typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 1.04 basis points to 26.25 basis points as of 11:05 a.m. in New York. The gauge, which has climbed from a six-month low of 24.69 on March 2, widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate bonds.

Bonds of American International Group Inc. are the most actively traded U.S. corporate securities by dealers today, with 89 trades of $1 million or more as of 11:08 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The Fed’s Comprehensive Capital Analysis and Review tested banks to ensure they have adequate capital to continue lending in a downturn and avoid a repeat of the crisis that resulted in a $245 billion taxpayer bailout through the Troubled Asset Relief Program.

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