Higher-Yielding Bank Debt Draws Interest    
Industry News

By: Mike Cherney

Source: online.wsj.com

Investors are scooping up riskier bonds sold by banks, betting on financial institutions' revival after a wave of regulatory changes since the financial crisis.

Money managers are buying so-called subordinated debt and other debt-like securities issued by banks, which are repaid after holders of other bonds that have more-senior claims on a bank's assets in a default. Because of this additional risk, subordinated bonds offer bigger interest payments than standard bonds.

The surge in demand has spurred highly rated banks to sell $21.8 billion of subordinated bonds in the U.S. so far this year, the fastest pace since 2007 and an 18% increase over the same period in 2013, according to data provider Dealogic. The higher yields on the bonds are luring investors amid historically low yields on what is considered safe government debt.

Investors say they are more comfortable with riskier bonds from banks such as Citigroup Inc., C +0.71% J.P. Morgan Chase JPM +0.98% & Co. and Wells Fargo WFC +0.84% & Co. after regulators imposed new rules to bolster banks after the crisis.

"Subordinated bank debt, especially in the U.S., offers perhaps the biggest opportunity in the fixed-income market right now," said Scott Carmack, who helps oversee $1.3 billion at Leader Capital Corp. The firm's largest fund, the $1.1 billion Leader Short-Term Bond Fund, has increased its exposure to subordinated bank debt to 25% of its portfolio from about 15% in the past year.

The market for subordinated debt was hammered after the collapse of Lehman Brothers Holdings Inc. and Washington Mutual Inc. WMIH -1.54% in 2008 hit some bondholders with big losses. The bonds' prices have largely risen since then as investors' fears about bank failures waned, including offering double-digit returns in 2012, according to Barclay’s data.

Thus far this year, subordinated bank debt has returned 5.22%, according to Barclays, including both bond-price appreciation and interest payments. That compares with a 2.51% return on senior bank debt and 5.08% on bonds sold by all highly rated companies.

To be sure, some investors are steering clear of subordinated debt. Alan Shepard, a portfolio manager at Madison Investment Advisors, which manages more than $15 billion, said yields on these bonds should be even higher to compensate investors for the risk compared with senior debt. A J.P. Morgan subordinated bond is yielding about 0.30 percentage point more compared to U.S. Treasurys than a senior bond.

Still, many investors say improvements in banks' financial measures mean the bonds' prices could still rise.

A measure of how much stock banks have that can absorb losses in a crisis, called the ratio of tangible common equity to tangible assets, rose to 7.86% at the end of the first quarter from 7.16% in 2011, according to Barclays, which aggregated figures from 25 U.S. banks. Buying subordinated bank bonds "allow you to add some yield," said Brian Monteleone, an analyst at Barclays.

David Brown, head of global investment-grade credit at Neuberger Berman Group LLC, which oversees $103 billion in fixed-income assets, said his firm has been buying subordinated bank debt. Mr. Brown said bank bonds are an attractive alternative to bonds from industrial companies, some of which are issuing bonds to pay for share buybacks and buy other companies. Both of those can be negative for a firm's existing bondholders by creating more obligations and reducing the amount of cash a company has on hand.

Investors are also flocking to preferred shares, which are often grouped with subordinated debt because they pay big dividends and can be bought back by the issuer at a specific date. Highly rated banks have sold $15.6 billion in preferred shares in the U.S. this year, the most since 2008 and up from about $12 billion at this time last year.

George Cipolloni, who helps oversee the $2.5 billion Berwyn Income Fund, said the fund was a heavy buyer of preferred shares, which would get paid before common stock, from J.P. Morgan in December, buying them at yields close to 7%. That is much higher than one of the bank's senior bonds due in 2044, which was issued in January with a yield of around 5%. The preferred shares remain outstanding in perpetuity but can be redeemed by J.P. Morgan starting in 2018.

Earlier this month, demand for subordinated corporate debt prompted Deutsche Asset & Wealth Management to launch what it says is the first exchange-traded fund to focus specifically on such debt.

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