It's Too Early to Buy Bank Debt

There are two things to notice here. First, stocks, high-yield, and financial corporate bonds have all been highly correlated. Second, performance of bonds tends to be smoother than stocks, even after correcting for scale, because bond performance is all about survival and liquidity, as opposed to stock prices which are about growth.

Now let's look at the period from May 7 through July 24. To make an easy comparison, we'll reset all the returns to zero and go from there.

Fall & Rise, Part 2

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Here we see that for most of May and June, our two corporate bond indices remained right around zero in terms of excess return. At the same time, financial stocks basically moved in a straight line down. Something had to give there, and eventually something did.

From May 7 to June 16, the financial corporate index had underperformed Treasury bonds by a whopping eight basis points (bps) and high yield had actually outperformed by 127. From then until July 24, financial corporate bonds underperformed Treasuries by 397 bps and high-yield by 509 bps.

Alright, so where does this leave us? Looking in total from May 7 to July 24, financial stocks have fallen 23.6% whereas financial bonds have fallen 4.05% vs. government bonds. That's about a 6-1 ratio. As of March 17, financial stocks had fallen 20% and financial bonds 6.5%, for a 3-1 ratio.

This implies that financial bonds remain overvalued vis-a-vis the equity. Now the counter-argument would be that the June-July stock market selloff was about equity dilution among banks.

If banks sell more equity, that actually benefits bondholders, and therefore bonds can remain tight even while the equity falls. I don't buy this argument.

Bank stocks have fallen to the point that public equity capital is unavailable. Troubled bank CEOs are more likely to roll the dice on recovering the equity, rather than dilute equity holders further.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.