US financials a better bet than corporates, say investors

The current pick-up available on US financials make them a better buy than corporates, according to some credit investors who argue the wider spreads do not correlate with a higher risk profile.

Bond investors have increased their exposure to US credit in recent weeks, following a period of heavy restructuring and improvement of company balance sheets, in the hope that the private sector will drive growth in the near term. But within corporate credit, some investors are seeing financials providing a better risk/return profile than their non-financial equivalents.

“US financials are trading wide to US corporates with few exceptions,” says Rick Patel, US dollar bond fund manager at Fidelity in London. “Wells Fargo, Citigroup, JP Morgan and Bank of America – the big four in the US – trade at wide levels relative to high-quality corporates and there is value in those securities over the medium term. In the short term, while you have negative headlines on the housing market and on consumers, that relationship may stay as it is but medium term there is good value.”

Within the Credit Suisse Liquid US Corporate Index, financials have generally traded wider than industrials since 2007. On September 16, the average spread of bonds issued by financials within the index closed at 175 basis points over Treasuries, while the comparative spread by industrial issuers was just 117.60bp, a difference of 57.90bp.

The gap in spreads would suggest much higher risk for financials. But Andrew Dalton, founder and chief investment officer of Dalton Strategic Partnership in London, says investors are attracted by the earnings and profits potential of financials.

"Consensus outlook for the next 12 months in the United States, for example, is that all S&P 500 companies, excluding financials, should produce further growth in earnings of about 19%," says Dalton. "And if you were to include financials the expectation is for profits to rise by 33%. This is current bottom-up analysts’ expectation for the US."

In recent weeks, concerns over regulation have replaced worries over peripheral European sovereign debt, harming the outlook for credit in financials more severely, according to Sven Kreitmair, head of corporate credit, non-financials, at Unicredit in Munich.

"The sovereign debt crisis and regulatory changes mainly affected non-financial corporate credits based in Ireland, Spain, Portugal and similarly overly-indebted countries," says Kreitmair. "In financials, all these 2010 topics affected the banking and insurance sectors much more than the non-financial sector."

Since June, however, Europe's sovereign debt problems have morphed from a crisis into a better understood, long-term theme, while the direction of financial regulation has become clearer and, some argue, less frightening to investors. But that changed outlook has not been priced in to financial spreads, investors say, making them a good relative value play.

"We believe that over the next six months, senior debt for financials offers better excess return opportunities than non-financial corporates based on significantly greater carry, due to wider spreads and more opportunity for spread tightening," says Steve Kozeracki, senior credit analyst at investment manager Vanguard in Valley Forge, Philadelphia.

He gives four reasons for his view. "Lower loss provisioning will provide an earnings tailwind. Secondly, uncertainty over US and international regulation and over the Goldman Sachs CDO case has subsided. Thirdly, we have more clarity on the scale and manageability of sovereign exposures. Finally, Basel III changes will, in time, created better-capitalised and more liquid institutions," says Kozeracki.

Volatility in financials will continue to overshadow volatility in non-financial corporates, Kozeracki adds, and all the more so as sovereign issues return, equity volatility remains high, high unemployment persists and fears of a double-dip remain at large. Yet that volatility will keep credit in financials cheap, given the positive fundamentals.

"The earnings tailwind from lower provisioning levels and greater recovery in prices of written-down financial assets provide more earnings growth potential for financials, not all of which has priced in," says Kozeracki.