Upbeat bond market at odds with banks over scale of Covid risks

A dramatic gap has opened in how banks and the bond market perceive the health of corporate America, with banks setting aside billions against bad loans even while bond prices suggest a dramatic recuperation from the Covid-19 shock. 

US banks’ loan loss reserves have risen by $110bn since the crisis began, and are now equivalent to 2.2 per cent of their loan portfolios, the highest level since after the financial crisis in 2012. 

Meanwhile, the difference in yield between US government debt and corporate bonds with the lowest investment-grade rating appears to indicate that the pandemic crisis is all but over. The spread has tightened from almost 5 percentage points in March to well under 2 points now — as narrow as it was early last year.

Historically, reserves and spreads have moved together. But market observers said they are now diverging because rock-bottom interest rates and the Federal Reserve’s backstopping of the corporate bond market have scrambled the signals transmitted by yields on company debt.

“Credit markets are looking at the relative risk for an investment and now they are looking in an almost zero-rate environment,” said Stuart Plesser, a bank analyst at Standard & Poor’s. “Those things just do not enter in a bank’s determination of whether they need to take a reserve.”

Banks’ reserving process is bound by economic models, accounting rules, and bank regulations, Mr Plesser said, not the supply and demand dynamics that have driven bond markets.

“It is a sign of the times — the whole world is desperate for yield, so anything that yields a positive number has a bid,” said Brian Foran of Autonomous Research.

The crucial factor is the Fed’s intervention in the bond market — it began buying investment-grade debt in June. That amplifies the difference between companies that typically turn to banks for financing and the generally larger companies with access to the bond market.

“The Fed is pretty much going to backstop investment-grade bonds through this crisis [so] spreads are very tight, even when the economy is not all right,” said Hans Mikkelsen, credit strategist at Bank of America.

“When you think about the loans on banks’ balance sheets, some of it is companies that could sell investment-grade bonds, but most of it is smaller, medium-sized companies, restaurants, other places that are struggling and that are not getting bailed out by the Fed,” Mr Mikkelsen said.

This is not true at all banks, however. At Bank of America, the largest lender in US with just under $1tn in loans, only about 7 per cent of the commercial loan portfolio is with small businesses. And while more than half of BofA’s loan loss reserves are for consumer loans, predominantly credit cards, it is not clear whether large-company credit quality could remain pristine if waves of consumers were forced into default.

One federal support package for small businesses, the Paycheck Protection Program, closed last month. The federal lending facility for medium-sized businesses, the Main Street Lending Program, has attracted only weak demand for borrowers, many of which said terms are too arduous. Prospects for further fiscal stimulus, meanwhile, are stalled in Congress.

The risk for holders of corporate bonds is that the banks setting their reserves could be right in their assessment of the likely default rate. That could leave investors who bought at high prices and low yields nursing losses.

But Alex Veroude, chief investment officer for Insight Investment North America, thinks bond spreads most likely give a more accurate view of credit risk than bank provisions.

“The question is, where are the defaults?” he asked. In the second quarter, credit card defaults declined, while commercial and mortgage defaults barely rose.

Mr Veroude thinks monetary and fiscal support have been sufficient to halt the credit cycle before it turns down. “The government programmes have stalled the [credit] rollercoaster at its highest point,” he said.

As a result, he said, even as cautious banks tighten their lending standards, markets have kept credit flowing through the economy. “The capital markets have effectively started to bypass the banks.”

This raises an unpleasant possibility for the banks: that accounting rules and regulation mean that they will struggle to offer companies funding at prices competitive with what is available in the bond markets. Reserving is a real cost for banks because increasing reserves means they must hold more capital on their balance sheets.

“Banks now [have] a seemingly higher cost of funding for underwriting credit risk than other providers of capital,” said a major bank investor this week. If this continues to be so, bond markets stand to take market share away from banks over the long run.

Additional reporting by Joe Rennison

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