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May 26, 2010

Banks Downgraded by Bondholders as Swaps Soar: Credit Markets

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By John Glover

May 26 (Bloomberg) — Bond investors aren’t waiting for ratings companies to act before downgrading BNP Paribas SA, Goldman Sachs Group Inc. and the rest of the world’s biggest financial institutions.

Bank debt yields 2.42 percentage points more than benchmark government securities, according to Bank of America Merrill Lynch’s Global Broad Market Financial Index. That’s approaching the 2.59 percentage-point spread on bonds rated as much as five levels lower than the index’s average Moody’s Investors Service grade of A1. The difference was as slim as 11 basis points this month, down from 177 basis points at the start of 2009.

Investors are marking down bank bonds on concern Europe’s sovereign debt crisis may reduce the quality of lenders’ collateral, while regulatory efforts to prevent a repeat of the seizure in credit markets crimps their profits. Banks may have a capital deficit of more than $1.5 trillion by the end of 2011 and some may require state support, according to Independent Credit View, a Swiss rating company.

Debt holders are “reacting first rather than waiting for events to unfold,” said Michael Donelan, who oversees $3.5 billion of bonds as director of trading and head portfolio manager at Ryan Labs Inc. The New York-based firm cut its holdings of financial company debt at the beginning of the month, Donelan said.

Bonds in the Bank of America Merrill Lynch index sold by BNP Paribas, France’s largest bank, yield an average 412 basis points, or 4.12 percentage points, more than Treasuries. The firm is rated Aa2 by Moody’s. Those of New York-based Goldman Sachs, ranked A1, pay a spread of 325 basis points.

Interest-Rate Swaps

Elsewhere in credit markets, the extra yield investors demand to own corporate bonds instead of similar maturity government debt rose 7 basis points to 196 basis points, or 1.96 percentage point, the highest since Oct. 22, the Bank of America Merrill Lynch Global Broad Market Corporate Index shows. The spread peaked at 511 on March 30, 2009, and dropped to as low as 142 on April 21. Average yields rose 2.4 basis points to 3.997 percent.

Two-year interest-rate swap spreads soared to the highest in 13 months before easing back in late New York trading, and the rate banks say they pay for three-month loans in dollars climbed for an 11th day. Credit-default swaps tied to company debt rose to the highest in 10 months and high-yield or junk bonds led by First Data Corp. tumbled.

The difference between the two-year swap rate and the comparable-maturity Treasury note yield, known as the swap spread, widened as much as 11.96 basis points to 64.21 basis points, before trading at 49.56 in New York. The spread has expanded from this year’s low of 9.63 basis points on March 24, the narrowest since 1993, as investors fled all but the safest government securities.

‘Cleanest Proxy’

“The two-year swap spread is the cleanest proxy to express a concern about increased systemic risk,” said Christian Cooper, senior rates trader in New York at Jefferies & Co., one of the 18 primary dealers that trade with the Federal Reserve. “Every day we walk in we’re seeing another headline bomb that pushes these spreads wider.”

The London interbank offered rate, or Libor, for three months advanced to 0.536 percent, the highest level since July 7, from 0.51 percent May 24, according to data from the British Bankers’ Association. Libor, a benchmark for about $360 trillion of financial products worldwide, ranging from mortgages to student loans, has more than doubled this year.

European Risk

“It’s all part of concern about the system, about whether the sovereign-debt crisis will morph into a bigger systematic crisis,” said Padhraic Garvey, head of investment-grade strategy at ING Groep NV in Amsterdam. “We’re not quite at a point where that’s imminent, but that risk is being priced in.”

Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, rose as much as 9.25 basis points to 134.5 basis points before falling back to 123.1 as of 5:23 p.m. in New York, according to Markit prices.

In London, the Markit iTraxx Crossover Index of 50 mostly junk-rated European companies climbed 41 basis points to 625.33, the highest since July 29. Contracts tied to Spain’s government bonds increased 54 basis points to 267, while South Korea rose 33 basis points to 176, CMA DataVision prices show.

First Data

Bonds of First Data, the credit-card processor bought by KKR & Co. for $27.5 billion at the height of the takeover boom in 2007, fell after Chief Financial Officer Pat Shannon resigned. The Atlanta-based company said May 14 that earnings before interest, taxes, depreciation and amortization fell to $424 million last quarter, from $472 million a year earlier.

The price on First Data’s $2.2 billion of 9.875 percent bonds due in 2015 dropped 5.25 cents to 78.125 cents on the dollar, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The debt was trading as high as 93.56 cents as recently as April 15.

Investors are ditching corporate bonds at the fastest pace in 19 months. High-yield debt has lost 3.6 percent this month, on pace for the first monthly drop since February 2009, and biggest loss since falling 8.43 percent in November 2008, Bank of America Merrill Lynch index data show.

Emerging-market bonds fell, as spreads widened 10 basis points to 348, from this year’s low of 230 on April 15, according to JPMorgan Chase & Co.’s EMBI+ Index.

Emerging Markets

Yields on Brazil interest-rate futures fell to the lowest level in a month. The yield on the contract due in January, the most active in Sao Paulo trading, dropped 6 basis points to 10.86 percent at 3:17 p.m. New York time.

Financial company bonds have lost 0.74 percent this month on average, compared with a gain of 0.52 percent for industrial companies, based on Bank of America Merrill Lynch indexes. Barring a rebound, that would be the biggest monthly loss since March 2009, when they tumbled 1.72 percent.

Of the issuers in the firm’s Global Broad Market Financial Index with the 10 widest spreads, all are in Europe but one, American International Group Inc., the insurer that needed four bailouts amid losses on credit derivatives. Paris-based BNP has the widest spreads, followed by fellow French lender Societe Generale SA, whose bonds have an average gap of 396 basis points.

Contagion Risk

The risk is “that the contagion spreads to financials or is accompanied by renewed bank failures,” analysts led by Mark Harmer and Jeroen van den Broek in Amsterdam wrote in a note to clients. “The effect on the already worsening money markets is clear to see.”

The study by Independent Credit compared estimated capital needs for the end of 2011 with capital ratios reported at the end of last year. The analysts took into account the banks’ earnings estimates, forecasts for loan and provisions growth as well as an increase in the tangible common equity ratio to 10 percent from the average of 9 percent at the end of December.

“Without state aid or debt restructuring these banks will hardly be able to raise capital,” Christian Fischer, a partner and banking analyst at Independent Credit, told reporters in Zurich yesterday.

About 2 trillion euros ($2.47 trillion) of debt issued by public and private borrowers in the so-called Club Med nations of Greece, Spain and Portugal is held outside those countries, according to Royal Bank of Scotland Group Plc.

Most Exposed

Banks are the institutions that are most exposed to the peripheral nations, with a total of about 1 trillion euros outstanding at the end of 2009, the firm wrote. German and French lenders, with claims against the three countries totaling almost 230 billion euros each, were the most exposed.

European leaders must address debt sold by nations such as Greece and Spain now to avoid a costlier bank bailout later, JPMorgan Chief Executive Officer Jamie Dimon said at the Japan Society’s annual awards dinner in New York on May 24.

In the U.S., Moody’s said last week it planned to see how lawmakers implement legislation approved by the Senate before deciding whether to cut bank ratings. Francesco Meucci, a Moody’s spokesman, and Standard & Poor’s spokeswoman Lisa Nugent, both based in London, declined to comment.

Spreads on Goldman Sachs bonds contained in the Bank of America Merrill Lynch index are up from 163 basis points in mid- April. Morgan Stanley’s spreads have jumped to 295 from 167, while Citigroup Inc.’s are at 306, up from 211.

The average yield top-rated financial firms pay to sell commercial paper due in 90 days jumped to a daily average of 0.47 percent last week, the highest since the period ended May 1, 2009, from 0.29 percent a month ago, according to Federal Reserve data. The gap in rates on the debt and the Fed funds rate reached an 11-month high of 34 basis points on May 21.

“The pressure has stepped up a notch,” said Peter Chatwell, a fixed-income strategist at Credit Agricole SA in London. “Things have taken a turn for the worse over the past month because of Europe’s sovereign debt crisis. It’s a multidimensional picture but all the dimensions look pretty grim.”

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