Optimism that the latest U.S. tarnished asset cleanup plan will refloat foundering banks may soon fade, triggering a renewed surge of risk aversion and selling of both financial firms' and industrial companies' corporate bonds, analysts said.
The U.S. government's stress tests for banks that are due to be finished by late April have raised concern among investors holding investment-grade corporate debt and may force companies to issue debt now for fear that yields will jump back to extremes and make borrowing even more expensive.
The risk is that some banks may fail the test, forcing them to ask for yet more government money.
Some corporate borrowers are trying to get to market ahead of the possible bad news about banks in case riskier assets sell off as a result.
Kedric Dines, an interest rate strategist at Mizuho Corporate Bank in New York said the bank had fielded several calls about this recently.
Some companies are calling to get their risk down, Dines said. People are really scared about this stress testing, about how bad a bank will look, so people have gone to their corporates and said 'issue now': get those deals across the finish line now.
U.S. corporate bond issuance has rebounded since the start of this year as more investors have ventured out of government bonds into riskier assets. The pace of U.S. corporate bond issuance has accelerated to $6 billion per day; the briskest clip since 2001, according to the 60-day moving average, said T.J. Marta, founder and market strategist with Marta on the Markets, a financial markets research firm in Scotch Plains, New Jersey.
The government aims to peel up to $1 trillion of bad assets off banks' books, unlocking credit and restoring the flow of loans. But a tougher assessment of how much more cash financial institutions need to survive the worst recession in decades could make banks look so shaky that investors will scramble for safer assets such as government Treasuries.
That factor of the stress tests is the sword of Damocles hanging over our heads, said Kevin Flanagan, fixed income strategist for global wealth management with Morgan Stanley in Purchase, New York.
Roughly 20 U.S. banks with assets over $100 billion will be subjected to stress tests. The government will not publicly disclose the results, but once supervisors determine how much additional capital a bank needs, the bank will have six months to raise private capital or opt to participate in the Treasury's new Capital Assistance Program.
Meanwhile, bonds of major banks are languishing as financial institutions continue to make write-downs and credit losses.
For instance, the costs to insure Citigroup against defaulting on its debt hit a record close of 621 basis points in early March for 5-year credit default swaps, according to Markit. The costs have since slipped to 581 basis points, meaning it costs $581,000 per year to insure $10 million in debt over five years: a level still reflecting investors' deep concerns about the quality of the debt.
The all-time high for U.S. financial entities bonds aggregated yield spreads over government Treasuries was just above 8 percentage points in the fourth quarter, a level retested in early March before it narrowed to 760 basis points on March 20, according to Morgan Stanley's data.
To be sure, if banks fare better than expected in the tests then their bond prices, which move inversely to yields, could surge.
If we go through all the stress tests and we find out that there are no more capital infusions needed, I would expect a rally in financials, said Flanagan. Even so, I wouldn't dive into the pool, he added.
Until the impact of the stress tests on major U.S. banks is clear, Flanagan said he would be very cautious about substantially raising exposure to those traditional bank bonds that are not guaranteed by the Federal Deposit Insurance Corp (FDIC) under the government's temporary liquidity guarantee program.
The type of bank debt that is not government guaranteed is really drawing a high-yield buyer or one using it as a substitute for equity, said Lawrence Glazer, managing partner of asset management company Mayflower Advisors in Boston.
(Additional reporting by Karey Wutkowski and Corbett B. Daly; Editing by Andrea Ricci)