By Katy Burne
Some investors are betting on a relief rally in bank bonds, and the credit-default swaps tracking them, with pending rating downgrades from Moody's Investors Service expected to be more benign than previously feared.
News reports have suggested that those rating actions from Moody's could occur as early as Thursday. The rating company's review of the banks, announced in February for 17 firms, was expected to be concluded by the end of June at the outset.
The cost of insuring the bonds using credit-default swaps has narrowed substantially this month, led by a 18% drop in the cost of five-year CDS protection on Morgan Stanley (MS) bonds since June 1, according to data provider Markit.
When CDS protection costs fall, it is likely because more market participants have been selling the insurance-like contracts, effectively betting that the underlying bonds will rise in value.
Other banks have benefited from similar improvements, with a 17% drop in five-year CDS costs for Goldman Sachs (GS) debt since June 1, 14% for Bank of America (BAC), 13% for Citigroup (C) and 12% in the case of J.P. Morgan Chase & Co. (JPM).
In early May, protection costs soared as investors became nervous about the coming downgrades alongside continuing worries about Europe's debt crisis and the health of the U.S. economy. Since then, Moody's said that a proposed set of rules designed to meet new international bank-capital standards would be a "credit positive" for U.S. banks.
Further highlighting the improving sentiment on banks in recent weeks was the gap between the cost of near-term and long-term CDS costs. Normally, five-year CDS costs are much higher than the cost of one-year CDS because investors believe there is more risk of default over a longer period.
When the cost of one-year protection rises up to meet five-year CDS, however, as it did with Morgan Stanley last month, that suggests investors are becoming concerned about near-term default risk.
The rise in near-term CDS narrows the gap between one- and five-year protection costs, flattening the slope that traditionally exists between premiums of both maturities, while a drop in one-year CDS signals that fears are abating and it steepens that CDS curve.
"Initially there were heightened concerns that Morgan Stanley could see as much as a three-notch downgrade," said Otis Casey, director in credit with Markit. "As this concern has subsided somewhat after Moody's indicated that capital requirements would be a credit positive for the banks, the CDS curve became more steep."
Mr. Casey said that the initial market reaction from the downgrades would likely depend on the action taken with Morgan Stanley, and whether it is a two- or three-notch downgrade.
Write to Katy Burne at firstname.lastname@example.org