Why Pimco is snapping up bank debt

The cost of protecting U.S. corporate bonds from default has fallen below yield premiums by the most since January as concern ebbs that the world’s largest economy will lapse back into recession, giving Pacific Investment Management Co. more reason to snap up bank debt.

Gaps between credit-default swaps and bonds have widened to 25 basis points from less than 2 basis points about three months ago, according to Citigroup Inc. Pimco, manager of the world’s largest bond fund, is finding as much as 1 percent of extra yield even after paying to insure bank debt, said Mark Kiesel, a managing director at the Newport Beach, California-based firm.

“This asset class is rebuilding capital very quickly,” said Kiesel, who is finding so-called negative basis trades with bank bonds paying excess yields of 0.8 percentage point to 1 percentage point.

U.S. central bankers may wait beyond their meeting tomorrow to announce additional steps to sustain the expansion, Pimco Chief Executive Mohamed A. El-Erian wrote on Pimco’s website. The Federal Reserve will cut its growth forecasts, El-Erian said. Still, home sales probably increased in August, a sign the real estate market is stabilizing, according to economists surveyed by Bloomberg.

The spreads Pimco is identifying in bank bonds and in the broader market compare with the average difference of more than 250 basis points after the bankruptcy of Lehman Brothers Holdings Inc. two years ago, just before bonds posted a record rally. The record gaps emerged as credit markets seized up, causing bond spreads to soar while demand for swap protection failed to keep up.

‘Capital Scarce’

An increase in negative basis is attracting buyers that seek to profit by buying the debt while also purchasing credit swaps.

“When capital is scarce, the basis becomes more negative,” said Alberto Gallo, a New York-based strategist at Goldman Sachs Group Inc. He said the basis should narrow as monetary policy and regulation reduce risk in the financial system and stabilize funding costs.

Elsewhere in credit markets, the extra yield investors demand to hold corporate bonds rather than government securities reached the narrowest since May last week. The finance arms of Fairfield, Connecticut-based General Electric Co. and Ford Motor Co. led $43.8 billion of U.S. corporate bond sales as issuance soared to the most in more than eight months.

GE, Ford

GE Capital Corp. sold $4 billion of three- and 10-year notes in the week’s biggest offering, according to data compiled by Bloomberg. Ford Motor Credit Co. sold $1 billion of five-year, 5.625 percent notes that climbed to 102.5 cents on the dollar on Sept. 17, from an issue price of 99.47 cents three days earlier, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. Ford is based in Dearborn, Michigan.

Prices on leveraged loans climbed to the highest since May. Benchmark credit-default swap indexes rose for the week, while in emerging markets, relative yields fell.

Spreads on company bonds shrank 4 basis points for the week to 171 basis points, or 1.71 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate index. That’s a decline of 10 this month in the index, which is the narrowest since May 17. Yields declined to 3.573 percent on average, from 3.637 percent on Sept. 10.

Bond Sales Climb

Bond offerings climbed to the most since the week ended Jan. 8 amid improving signals for the U.S. economy. The Labor Department reported initial jobless claims fell in the week ended Sept. 11, while the Commerce Department said retail sales climbed in August for a second straight month. This month’s bond issuance of $87.6 billion compares with $79.1 billion through Sept. 17, 2009.

Tomorrow, the Fed meets to set monetary policy. A survey of bond investors overseeing $1.34 trillion by Ried Thunberg ICAP, a unit of the world’s largest inter-dealer broker, found that 57 percent of respondents don’t expect the Fed to announce additional asset purchases at the meeting, while 43 percent expect policy makers to say they’re resuming quantitative easing.

Worldwide, corporate debt sales fell 13 percent to $92.6 billion from $106.8 billion in the week ended Sept. 10, Bloomberg data show. Global issuance for the month is even with last year’s pace at more than $234 billion.

Leveraged Loans

The Standard & Poor’s/LSTA US Leveraged Loan 100 Index rose 0.28 cent for the week to 89.95 cents on the dollar, the highest since May 19. The index, which tracks the 100 largest dollar- denominated first-lien leveraged loans, has returned 5.03 percent this year, building on a gain of 3.86 percent through August.

The Markit CDX North America Investment Grade Index Series 14, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, climbed 1.06 basis points last week to 103.88 basis points, according to prices from Markit Group Ltd. The index, which typically rises as investor confidence deteriorates and falls as it improves, has declined 10.6 basis points for the month.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings rose in each of the last four trading days, ending the week 2.6 basis points higher at 107.52, Markit prices show. The index has declined from 118.18 on Aug. 31.

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.

‘Less Attractive’

In emerging markets, relative yields fell 2 basis points for the week to 275 basis points, according to JPMorgan Chase & Co. index data. Spreads have declined from 299 basis points on Aug. 31.

The widening gap between U.S. corporate bond spreads and the cost of credit swaps on the debt may be exacerbated by the highest bond prices in six years. As prices rise above 100 cents on the dollar, the cost to hedge against default also rises, eroding the potential excess yield, Goldman Sachs’s Gallo said.

“Higher prices also make it less attractive to enter new trades, since you have to buy more CDS protection to hedge the full value of the bonds,” he said.

Assenagon Asset Management, which last year started a fund to profit from the basis between bonds and credit swaps, is still finding attractive gaps at the cusp of investment-grade and high-yield and in European government debt, said Jochen Felsenheimer, Assenagon’s Munich-based co-head of credit.

Pimco Favors Banks

“The fact that negative basis is still available just means there are still structural distortions in the market,” he said. “So it is an indication that the crisis is still there — not as obvious as was probably the case two years ago, but it is not gone.”

High-yield debt is rated below Baa3 by Moody’s Investors Service and lower than BBB- by S&P.

The biggest gaps among U.S. bank bonds are in debt due between 2017 and 2020, said Pimco’s Kiesel, who in March called bank securities the best investment in credit markets.

“The fundamentals are turning more positive,” he said. “The banks are basically not making as many loans, so there’s not as much need for issuance. Deposits are very high. So the banks don’t need the cash. The rollover risk for U.S. banks is very small, particularly relative to U.K. and European banks.”

Bank of America Corp.’s $3.5 billion of 5.75 percent bonds due in 2017 are paying an asset-swap spread over benchmark interest rates that’s 99 basis points more than the 161 basis points it costs annually for seven-year credit swaps on the debt, data compiled by Bloomberg show. The gap has doubled since January, when it was as low as 44 basis points.

“It makes sense as a relative value trade,” said Mikhail Foux, a credit strategist at Citigroup in New York. “Overall, it makes a lot more sense to be long cash right now and have CDS overlays as hedges.”

Related Topics: Pacific Investment Management Company (Pimco)