Pimco’s investment professionals spent three days this month with the likes of Alan Greenspan, Nassim Taleb, and Mike Spence in something the bond manager calls its "Secular Forum". It fell to Mohamed El-Erian to sum it all up, and to draw some investing ideas from the discussion. The most interesting one, to me, is that this might be a great time to buy bank debt. Writes El-Erian:
As investment banks are forced to converge over the next few years towards the lower leverage model of commercial banks, they will seek ways to secure a deposit base that can reduce their cost of funding, including through merger and acquisition. This process of de-leveraging and, if done properly, de-risking will have a number of implications for investors…
Expect us to search for value in the re-alignment of the financial system that is heavily influenced by regulatory-induced de-risking: The regulatory reaction serves to clip part of the tail risk of institutional failure but at the cost of an unambiguous decline in the expected return on capital – a phenomenon that will tilt relative value in the direction of bond holders and away from equities.
While there might yet be a few unexploded grenades in banks’ balance sheets, I think El-Erian is probably right that over the foreseeable future, banks are likely to become safer, not riskier, institutions. If that’s the case, then buying bank debt now, when spreads are extremely wide, makes a lot of sense. Yes, there’s risk involved – but you’re being compensated for the risk with the spread. And over the medium term, those spreads are likely to come in substantially – even if the share prices of the banks in question don’t recover at all.
(Plus, of course, there’s the moral hazard play. If Bear Stearns and Northern Rock bonholders came out of an ignominious collapse whole, then the chances are most other bank bondholders are likely to get bailed out as well.)