Should you avoid bank bonds?

bank of americaA year ago, Learn Bonds was suggesting that investors looking for additional yield might consider financial bonds. Goldman Sachs bonds maturing in 10 years were yielding a tad above 5.0%.  While treasury interest rates are more or less the same as they were a year ago, the rate on 10 year bonds issued by  Goldman Sachs are much lower. Goldman Sachs bonds are now yielding between 3.5% and 4.0%. Yields of all bank bonds have come down tremendously over the last year compared to non-financial bonds. In fact, the yields on industrial bonds and financial bonds are now comparable.

  To see a list of high yielding CDs go here.  

An investment Choice: Bank Bond ETFs or Industrial Bond ETFs

Until recently, you had little ability to avoid completely or concentrate your investments in financial bonds, unless you were buying individual bonds. The largest bond ETFs (AGG and BND) have their corporate bond fund exposure almost evenly divided between financial and non-financial bonds.  However, in February 2012 iShares came out with the Industrials Bond ETF (ENGN) and Financial Bond ETF (MONY), enabling investors to tailor their exposure.

Since inception, ENGN has gained 4.96% while MONY has risen 8.65%. The SEC yield on the two funds is currently at 2.48% for ENGN and 2.13% for MONY. After adjusting for the difference in the average maturity of the bonds these ETFs hold, the yield for industrial bonds and financial bonds are about the same. As the yield for these two types of bonds is about the same, the question becomes which type of bond is safer?

 

The FED Versus Inherent Vulnerability Of Financial Bonds

The last time that financial and industrial bonds had similar yields was in 2007, when the upcoming financial crisis was only on the radar screen of a few very smart hedge funds and traders.  After the financial crisis hit, non-financial bonds did much better than their counterparts. At one point in 2009, the difference in yields rose to 4.0%.

In the wake of the financial crisis, several financial companies went bankrupt (Lehman Brothers) or needed government bailouts (AIG). Most financial firms are dependent on the markets for the most important input in their business, CASH. As the financial markets tend to react quicker and more severely to changes than the overall economy, financial firms were impacted the most.

Over the last five years, the Federal Reserve has taken multiple initiatives to soothe the financial markets (lower short-term rates to zero, loaning money to banks, buying up bonds). The markets have been convinced that the Federal Reserve will prevent the market from starving financial firms from cash.  With this confidence, the difference in yields between financial and industrial bonds has disappeared. This process may have occurred a year or two earlier, however the market got rattled by the Greek default and financial instability in Europe.

 

All Things Being Equal, I Would Rather Not Own Financial Bonds

Financial Bonds have two qualities that I don’t like:

1) When something goes wrong, things tend to explode very quickly. When a financial company goes bankrupt, the process of going from investment grade to bankrupt typically takes only 2 years.

2) In bankruptcy, the recovery rate on debt is around 15% less than the market average.

For more information on this topic, click here.

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