Are Bank Bonds Cheap? GS, BAC, MS Offer 5% Yields

February 17th, 2012 by

Yesterday, the following bonds made FINRA’s list of the most actively traded bonds:

10 Year Goldman Sachs (GS) bonds are yielding 5.04%

4 Year Morgan Stanley (MS) bonds are yielding in 4.59%

10 Year Bank Of America Bonds (BAC) are yielding 5.04%.

All of these bonds are investment grade, in fact, rated A- by S&P. According to the Bond Desk Group, 5 – 10 year financial corporate bonds with an A rating offer on average 2.97% more yield than non-financials with similar maturities and ratings.

A 3% difference is tremendous.

Is it justified? The idea for this article came from ZeroHedge. They were pointing out that stocks in the financial space were rallying and the bonds were not. In theory, the positive economic news that has been propelling stocks in the space should also help bank bonds. However, lets talk about risk / reward.

The primary concern these days is Europe. Lets assume there is a European crisis. Financial companies, particularly the global ones like Goldman and Morgan Stanley, will be hurt. Because of the nature of their business, financial companies depend on trust more than any other industry. Titans can disappear (Lehman, Bear Sterns) in a matter of weeks when the trust disappears. A non-financial company can be salvaged from a missed bond payment or not paying their bills for a couple months. A financial company cannot. This difference could be a major reason why the yields are so high on financial bonds. If the European financial crisis does not get worse but slowly drifts in the background, one could expect this almost 3.00 spread to narrow by 1 maybe 2 percent making financial bonds a great investment. In this case, a financial bondholder might make a 20% return on their investment. On the other hand, if the US economy continues to improve and the European crisis does not happen, stock holders might see a 50% return. This might explain why the bonds of financial companies are reacting more cautiously than their stocks.

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