U.S. banks are quietly making plans to protect themselves from a slowing domestic economy, potentially giving investors the chance to profit from some of the very bonds that many bank bosses resisted issuing when regulators overhauled the sector in the wake of the global financial crisis.
While the current bull market in stocks — at ten years and counting the longest in history — starting to show signs of fatigue, governments, central banks and agencies around the world are cautioning on slower growth that could lead to an inevitable downturn or, at worst, global economic recession.
The U.S. isn’t immune, either, and while GDP expanded at a healthy 3% pace last year, Morgan Stanley thinks there’s a 15% chance of recession in 2019, with the odds rising to 30% in 2020.
“They’re not predicting a recession, but they’re preparing for one,” said Jon Curran, a global corporate bond fund manager at Aberdeen Standard Investments, in a recent interview with TheStreet shortly after meeting with executives at JPMorgan Chase & Co (JPM) .
Banks are actively “de-risking their mortgage businesses” by lending less to home buyers, and they’ve “backed off in auto lending”, Curran said, through a series of moves he describes as “surgical pullbacks” in the event of a downturn.
However, unlike pre-crisis 2008, the U.S. banking system is well prepared for a shock, not only on account of new regulations, but also on account of bank executives themselves.
“Even the larger banks, when you get to talking with them privately – the overall system is much safer today than it was pre-crisis,” said Democratic Senator Mark Warner of Virginia. “Many [bank executives] will acknowledge the system is much safer.”
That comes as a surprise to many long-time market participants, who watched bank bosses resist moves by regulators to make their businesses and lending practices safer even as they picked through the trillion dollar wreckage of the financial crisis.
And now, with the U.S. economy slowing — the Atlanta Fed’s GDPNow tracker has first quarter growth running at just 0.4%, investors looking for portfolio protection can ironically look to the very bonds banks were forced to issue in the wake of the crisis in order to insulate themselves against the very downturn the banks themselves see emerging in the near future.
Whether you’re an aggressive investor betting on more juice left in the squeeze of the current expansion, or looking to protect yourself from the rotting fruit of a slowdown, capital preservation and high yields are difficult to find.
Step forward bank capital bonds, one of Curran’s most confident investments at present.
“We have overweight positions in bank bonds,” he said, as the “loan quality looks very good.” Usually, higher quality, less risky bonds have lower yields, and while bank debt certainly isn’t high yield, some of these bonds are “right around 4%,” Curran argues.
That’s a strong yield for its credit profile compared to U.S. investment grade bonds, which currently yield around 3.7%, according to data from the Wall Street Journal Market Data Center. Compared to risk-free treasury bonds yielding 2.63%, bank debt is arguably premium as well.
The case for the trade is sound: while banks are looking at more modest near-term profits, thanks in part to a flatter yield curve that makes longer-term lending less attractive, they’re safer than ever before.
U.S. banks’ common equity tier 1 (CET 1) ratio’s — which measure the cash and capital banks need to set aside to cover potential losses — are now required to be at a minimum of 4.5%. That’s up from just 2% in 2011, according to the Journal of Risk and Financial Management.
In fact, says Senator Warner, “you still have some of the larger institutions complaining that that we have higher capital standards than EU counterparts.”
JPMorgan’s current CET ratio 1 is 14.45%, while Germany’s Deutsche Bank’s (DB) is 13.6%. Still, as those ratios have fluctuated, Bank of America’s (BAC) is at 11.6%, lower than HSBC’s (HSBC) , Europe’s biggest bank, at 14%.
Warner, one of the engineers of the Dodd-Frank Act, which installed a wide-ranging system of bank requirements and standards to safeguard the banking system from another near collapse, says complaints about the changes, including from President Donald Trump, have turned to silence.
“I hear virtually nothing from the admin on further roll-backs of Dodd-Frank,” he told TheStreet.
Inflation, the enemy of any bond investment because it erodes the present value of future interest cash flows, is also tepid enough for the Federal Reserve to have revered course on rate hikes earlier this year, providing a further bullish backdrop for fixed income plays.
Furthermore, while many have touted dividend stocks as a solid place to park one’s capital, high dividends are hard to find: the average dividend yield of an S&P 500 company is currently roughly 1.91%, meaning an investor must be completely assured he or she won’t lose principal, given that there isn’t a huge number of high yielding dividend stocks out there.
While banks prepare for a potential recession, so should investors, and there may be a few good bargains out there.