Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 14 May 2012

Investing in banks after JP Morgan's debacle


Investors in bank stocks must be feeling as if they’ve been hit by the Cruciatus curse. It was all going so well with the S&P 500 Financial Sector Index registering a 20% YTD gain. Then came JP Morgan’s shock $2bn loss which led to its stock plummeting more than 10% and dragging the rest of the sector with it. Although still up on the year, investors need to reconsider whether owning bank stocks makes sense. The gut wrenching volatility and renewed realisation that equityholders are the first loss piece of what are effectively black box trading operations should prima facie weigh against owning bank stocks. Add to it the negative impact to earnings and RoE from stricter regulation and higher capital limits, the investment case starts looking weaker. JP Morgan’s debacle is a disaster for the banks in their war against regulation. The fortress has been breached from within.

However, this does not mean one should impulsively sell all bank stocks or even get out of the sector completely. There are always relative value plays within the sector. But more interestingly for a long-only retail investor willing to take exposure to the banking sector, it might be better to invest in bonds rather than common stock. The reasons are three fold. First, the principal is protected in bank bonds due to sovereign backing. The government’s response to the financial crisis shows that banks will not be allowed to fail. In the current low interest environment, senior unsecured bank bonds offer a significantly higher yield than 5-year treasuries at 0.71% for not much more credit risk. The cost of this semi-explicit support is going to be borne by equity holders and the benefits are to be enjoyed by the bondholders (and the Iksil-lent management of these firms).

Second, the yields on offer are certain compared to uncertain EPS and DPS. Increased regulation, higher capital requirements, flattening yield curve, shutdown of the fixed income money machine, inflated cost base and the danger of investment banking “rogues” cropping up are just some of the headwinds to earnings that equityholders face. Bondholders in contrast will have to be paid by a going concern.

Third, current senior unsecured bond yields are higher than dividend yields for most banks (Table 1). And for some like Bank of America and Morgan Stanley, they are even higher than earnings yield. This implies that equity holders are dependent on capital appreciation to achieve returns at par or higher than bonds. Unless banks can achieve this difficult task of delivering capital appreciation in a deleveraging environment, bonds will provide superior returns.

For investors with greater risk appetite, moving down the bond seniority structure can provide an even higher yield. However, it also increases risk and introduces uncertainty of principal repayment due to call optionality embedded in subordinated bonds. Moreover, liquidity is poorer and associated bid-offer spreads wider leading to a less than commensurate increase in return for the enhanced risk.

Table 1: Comparative equity and senior unsecured bond returns for US banks
Bank
Earnings yield (E/P)
Dividend yield
Current Bond Yield (~5 year)
(CUSIP)
Bond yield / Dividend yield
Bank of America
-2.28%
0.53%
4.291% (06050TKW1)
8.09
Citibank
12.5%
0.14%
3.872% (172967EH0)
27.66
JP Morgan
12.4%
3.32%
3.369% (48121CVZ6)
1.01
Goldman Sachs
6.75%
1.83%
4.360% (38144LAB6)
2.38
Morgan Stanley
1.36%
1.38%
5.164% (617446V71)
3.74
Wells Fargo
8.90%
2.69%
2.193% (929903DT6)
0.82
Source: Google Finance, FINRA

In the final analysis, investors who are negative on the banking sector can still take advantage of the moral hazard engendered by the SIFI (Systemically Important Financial Institution) designation by buying bank bonds. For those who are more optimistic about the sector and the earning ability of banks, a mixed portfolio of common stock and bonds is preferable. Banks stocks with low bond-to-dividend yield and bond-to-earnings yield ratios can be combined with bank bonds with high ratios to get the best of both worlds. 

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