Some investing pros have offered warnings lately about the many dangers of bank bonds, but there's one pitfall they may be missing: The sector is dominated by so few companies, investors may be taking on more risk than they know.
The financial sector, which includes banks, insurance companies and financial services firms, has long dominated the corporate bond market, experts say. About 40% of monthly corporate bond purchases in March came from the same top 20 issuers 17 of which were financial firms, according to BondDesk Group, a retail bond trading platform. That percentage is roughly the same as in June, when the firm started tracking purchases. The top five firms General Electric, Bank of America, JPMorgan Chase, Goldman Sachs and Morgan Stanley currently account for nearly one-quarter of those sales alone.
But while that high concentration of sales amongst so few players may be nothing new, it does make the financial sector of the corporate bond market much more vulnerable to a crash, says Lon Erickson, a corporate bond fund manager for Thornburg Investment Management. "A liquidity problem at one bank could cause a liquidity problem at another," he says. And those fears may spread quickly to other fixed-income sectors. It was only three years ago that Lehman Brothers defaulted on its debt, causing the entire bond market to freeze and forcing some bond investors to take major losses.
On top of those risks, experts say improving fundamentals amongst banks and financials -- many have been growing earnings and paying off debts, including loans from the Troubled Asset Relief Program -- will continue to make these bonds more expensive and shrink yields. Investment grade bank-issued bonds currently yield an average of 4.3%, while similarly rated bonds issued by other financial services firms return 4.4% -- both surpassing the average 3.9% for all investment grade corporate bonds and 3.5% for 10-year Treasurys, according to Standard & Poor's Global Fixed Income Research. But those spreads have been narrowing steadily since March 2009, when the market bottomed out. Mr. Erickson, for example, says he increased exposure to financial sector corporate bonds from institutions like Bank of America and Citigroup after the financial crisis but has already started selling some of those bonds.
Not everyone is turning cautious on bank bonds. "Financials are still cheap," says Krishna Memani, director of fixed income at Oppenheimer Funds. Indeed, as of March 31, mutual fund managers and other institutions held $1.4 trillion in financial sector bonds, up 7% from December 2009, the earliest year for which data is available, according to Ipreo, a provider of market data and analytic services. Even retail investors have been getting in on the action: 54% of the bond purchases of $100,000 or less in March were for financial and bank bonds, according to BondDesk Group. That ratio has held steady since June, when BondDesk began tracking the data.
For those still interested in bank bonds, experts recommend that investors minimize risk by seeking out diversified corporate bond funds with exposure to several sectors. Also, look for funds with below-average expense ratios, a strong track record of performance and stable management. Todd Rosenbluth, mutual fund analyst for Standard & Poor's Equity Research, recommends the T. Rowe Price New Income fund,