US banks are starting to ramp up purchases of everything from mortgage-backed securities to collateralized loan obligations after nearly two years of cutting back, adding fuel to a multi-month rally across credit markets.
Citigroup Inc., JPMorgan Chase & Co. and Bank of America Corp. have been boosting purchases of top-rated CLOs. Commercial bank holdings of mortgage bonds are also on the upswing, climbing 12 of the last 15 weeks, according to Federal Reserve data. It comes as Wall Street buyers added $41 billion of securities to their portfolios in the three months through December, according to data compiled by Citigroup, ending a streak that saw them shed more than $800 billion since March 2022, separate Fed data show.
Amid an upturn in deposits, banks are searching for ways to put this new cash to work. The traditional option — boosting lending — is hard to do right now, though, after two years of interest-rate increases that curbed loan demand and pushed up defaults. That’s left banks to park more money in high-quality securities that they believe will boost returns without heaping on too much credit risk.
The renewed demand, while thus far modest, is already helping propel gains across credit, market watchers say. Spreads on new CLOs have tightened to the narrowest in more than a year-and-a-half in recent weeks, while MBS have rebounded from historically cheap levels. Further signs that banks are adding to their CLO and MBS holdings will only bode well for those markets, according to John Kerschner, head of US securitized products at Janus Henderson.
“The credit rally has multiple drivers, but an important piece of it is bank demand and we’re expecting only to see more of that,” Kerschner said.
US bank deposits are on the rise again after tumbling in the wake of Silicon Valley Bank’s failure last March. Bolstered by higher yields paid on savings accounts, deposits climbed almost $500 billion between April and the end of 2023, according to Fed bank report data compiled by Barclays Plc.
The largest banks have historically stashed much of their holdings in high-quality debt such as Treasuries and agency MBS, preferring to take credit risk in their loan books and to stick to interest-rate risk in their bond holdings.
In agency MBS, where banks have largely been missing in action for over a year, holdings have climbed by $74 billion since late October. The reversal has coincided with dramatically tighter spreads.
The yield gap on newly issued Fannie Mae current coupon MBS narrowed to 1.39 percentage point earlier this month, from as high as 1.89 percentage point four months ago, according to data compiled by Bloomberg.
CLOs, which bundle leveraged loans into slices of varying risk and return, are also proving popular because their floating payouts help protect against the risk of rising interest rates eroding the market value of banks’ portfolios, essentially what happened to SVB prior to its collapse.
In addition, the highest rated slices of CLOs get relatively lenient treatment under new Basel III capital rules, which are poised to be finalized later this year.
“Some banks are coming to the market now looking to add CLOs for the first time,” said Ian Wolkoff, a managing director at Pretium Partners. “We think banks should have been buying CLOs earlier. The problems they faced last year could have been avoided with floating-rate assets.”
Banks have also plowed cash into Treasuries in recent months, adding $54 billion in the fourth quarter, according to a Citigroup analysis of bank holdings.
‘CMO Machine’
Appetite is also growing for a type of securitization known as collateralized mortgage obligations. Newly issued CMOs accounted for about 18% of overall agency MBS issuance in January, up from an average of 11% over the last three years, according to data from Robert W Baird & Co.
“Banks are the major driver of CMO demand,” said Kirill Krylov, a strategist at Robert W Baird. “If they’re asleep, then there’s not much CMO production. “If banks are active, the new issue CMO machine is working overtime.”
Some market watchers are quick to point out that the growth in bank deposits is still in its early days, and should the trend reverse, it’s likely that securities purchases will too. If loan demand picks up, banks could also look to boost their lending books.
Given the significant presence the largest US banks command in these markets, were just a handful to decide to turn off the spigot, demand for mortgage-backed securities would likely dissipate just as quickly as it emerged, creating idiosyncratic risk and performance, according to Bloomberg Intelligence senior MBS strategist Erica Adelberg.
Still, their renewed purchases are already having an impact, says Tracy Chen, who leads global structured credit investing at Brandywine Global Investment Management.
“Banks are really big players, and the fact they’re getting more involved means we can expect some tightening,” Chen said.
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