CREDIT BACK TO NORMAL ? / THE WALL STREET JOURNAL

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SEPTEMBER 17, 2009, 8:56 A.M. ET

Credit Back to Normal?

By RICHARD BARLEY

Business as usual? Not for everyone. For blue-chip nonfinancial companies, the credit markets may be booming, a stark contrast to the freeze one year ago in the wake of the collapse of Lehman Brothers. But one critical part of the market is still not sounding the all-clear: the market for bank and other financial company bonds.

This may be unsurprising: banks have needed unprecedented support to survive the crisis. In the last 12 months, 51% of financial bonds issued globally have carried government guarantees, according to Dealogic. Some banks are still taking advantage of this support: witness Citigroup's sale of $5 billion of guaranteed debt this week. Subordinated bank debt has seen particular turmoil as investors have realized that this product can behave much more like equity than they expected it to.

What's puzzling is the continued weakness in the safest financial debt. Senior financial euro-denominated bond spreads are currently 20 basis points wider than on non-financial bonds, whereas pre-crisis they would have been 15-30 basis points tighter, according to Deutsche Bank. Similar trends can be seen in dollar and sterling debt.

This is counterintuitive. First, it means banks are paying more to borrow than their blue-chip corporate clients, which seems unsustainable. Second, bank senior debt is rated on average 2.5 to three notches higher than nonfinancial debt. Third, governments have gone out of their way to keep senior debt payments flowing even when banks have been nationalized. And fourth, future regulatory changes are likely to make senior debt safer via bigger, better-quality capital buffers and caps on balance-sheet leverage.

True, this dislocation may simply reflect the relative lack of new senior financial bond supply to validate prices and generate spread tightening. As in the corporate bond market, any illiquidity premium might fade as issuance accelerates.

A better explanation is that bond investors are still worried about the state of the global financial system. Indeed, this may be one of the few visible signs of continuing investor skepticism, given that quantitative easing is distorting signals from the government bond markets and helping to pump up equity market sentiment.

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