Less than a decade after the last major banking crisis, Goldman Sachs Group Inc. and JPMorgan Chase & Co. are offering investors a new way to bet on the next one.
The two financial giants are now making markets in derivatives that allow investors to bet on or against high-risk bank bonds that financial regulators can wipe out if a lender runs into trouble. Others are also planning to start trading the contracts, known as total-return swaps, in the coming weeks, according to Max Ruscher, the London-based director of credit indexes at IHS Markit Ltd., which administers the benchmarks that the swaps are linked to.
At a time when financial markets are racing from one high to another, and even the new Nobel laureate in economics is wondering aloud about investor behavior, the development is at once a sign of the headlong global race for investment returns and nagging worries that the investors may be getting ahead of themselves.
Underlying these trades are securities known as additional Tier 1 notes, which banks started issuing after the European debt crisis. They seek to protect taxpayers from bearing the cost of government bailouts, bringing with them relatively high yields. In an era of near-zero interest rates, they’ve become sought after by debt investors around the world, ballooning into a $150 billion market.
The average yield on the debt has fallen this year to about 4.7 percent from 6 percent, based on Bank of America Merrill Lynch index data. It’s still around 10 times the return for senior bank bonds.
Goldman Sachs analysts have expressed skepticism about whether the yield is worth the risk. Louise Pitt and Nick Caes, based in New York, recommended in July that investors “be more cautious on AT1 spreads” and switch to better-protected securities.
Tier 1 capital is a “shock absorber” that banks can use to boost their balance sheets in an emergency, while imposing losses on creditors, Jim McCaughan, chief executive officer at Principal Global Investors, said in an interview on Bloomberg Television. That could create a negative “feedback loop” for traders, he said.
“I don’t believe it’s a danger yet because I don’t think there’s that speculation going on in a big way,” he said. “But watch this space and be very wary of this.”
At least some of the demand for the new derivatives is coming from investors looking to protect themselves should prices of the debt drop -- or should another banking crisis erupt. Those risks emerged in June, when AT1s issued by Banco Popular Espanol SA were wiped out as part of a bank rescue.
“Some participants are looking to get exposure to an asset class while others are hedging their positions,” according to a report on IHS Markit’s website. “On one side of the TRS trade, the index buyer anticipates that the total return of the index will rise. The index seller on the other side takes the opposite view.”