Bonds of Wall Street’s biggest banks are the least volatile since the credit crisis as confidence mounts that new regulations aimed at reducing leverage have made the financial system safer.

Relative yields on dollar-denominated bank notes withstood the selloff in May and June better than in any downturn since 2008, widening 1.3 times as much as the broader corporate bond market, compared with 3 times at the peak of the credit seizure, according to Barclays Plc data. Average spreads on financial bonds of firms from Morgan Stanley to Macquarie Group Ltd. outperformed industrial debt last month by the most since November, Bank of America Merrill Lynch index data show.

Five years after the crisis that led governments worldwide to bail out the banking system, investors are regaining faith in its debt as lenders reduce holdings of riskier assets and cut proprietary trading units in response to higher capital requirements and new rules. Strategists at Bank of America Corp. and Barclays are recommending investment-grade bond buyers hold the notes even after they beat industrials by almost 10 percentage points since the end of 2011.

“Prior to the financial crisis banks were very low beta, banks were considered by the market to be very safe,” said Hans Mikkelsen, head of U.S. investment-grade credit strategy at Bank of America in New York. “That’s where we’re going once again.”

Favoring Banks

Bank bonds were considered safer than industrials in the 10 years before Lehman Brothers Holdings Inc.’s bankruptcy ignited the worst credit crisis since the Great Depression, with investors demanding less extra yield over government debt to own them. In the four years after Sept. 15, 2008, their relative yields were an average 117 basis points wider than industrials, Bank of America Merrill Lynch index data show. The gap has shrunk to 8 basis points as of July 31.

Buyers have been gravitating back to the notes as they view rising interest rates as a bigger risk than a disruption to the banking system with Federal Reserve policy makers debating when to taper stimulus that’s pushed borrowing costs to record lows. In addition to strengthening balance sheets, financial debt typically has shorter maturities than industrial notes, reducing its sensitivity to rising interest rates.

Ford Bonds

“From a bondholder’s point of view, it’s going to be good having those stronger capital withholding requirements,” said Brian Machan, a Des Moines, Iowa-based money manager at Aviva Investors North America In. who helps oversee $433 billion and is overweight bank bonds. “With the steeper Treasury curve, that’s going to help banks too. We have liked the banking sector.”

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. decreased, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declining 1.1 basis points to a mid-price of 73.2 basis points as of 11:44 a.m. in New York, according to prices compiled by Bloomberg.

The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Rate Swaps

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.1 basis point to 17.4 basis points as of 11:44 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Morgan Stanley, owner of the world’s biggest brokerage, are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.9 percent of the volume of dealer trades of $1 million or more as of 11:45 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Debt of New York-based Morgan Stanley and Macquarie, Australia’s largest investment bank, led a 1 percent return for dollar-denominated bank bonds in July, compared with a 0.6 percent return on industrials, Bank of America data show. Morgan Stanley’s notes generated excess returns of 1.8 percent while Macquarie’s were up 1.7 percent.

Basel Rules

“If I had to pick a sector of the investment-grade corporate-bond market that was most attractive, I’d point to financials,” said Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., which oversees $350 billion. “Financials have attractive fundamentals, improving credit quality metrics and valuations are more compelling relative to industrials.”

To help prevent another financial seizure, the 27-country Basel Committee on Banking Supervision voted to raise minimum capital requirements in 2010 and U.S. Congress passed the Dodd- Frank Act seeking to limit banks’ trading with their own money.

The 21 primary dealers that trade with the Fed cut their corporate-debt holdings by 76 percent from the peak in 2007 through the end of March, Fed data show.

BNP Paribas SA, France’s largest bank, said on July 30 that it already meets more stringent global standards on leverage, a day after Deutsche Bank AG and Barclays announced plans to shrink.

Improving Fundamentals

Bank of America, the second-largest U.S. bank, estimated last month that its ratios of capital to total assets are close to the proposed U.S. minimum, and Lloyds Banking Group Plc said yesterday it will seek to resume dividends, five years after receiving a taxpayer bailout.

Revenue at the six biggest U.S. banks climbed to $215 billion during the first six months of the year, compared with $208 billion for the same period in 2012, Bloomberg data show. It was the first time revenue rose during the period since 2009 and came as consumer confidence improved, the housing market rebounded and stocks reached record highs.

“Bank fundamentals have continued to improve quite significantly over the past couple of years,” said Shobhit Gupta, a strategist at Barclays in New York. “The lower volatility is, the better the risk-adjusted return.”

Investment-grade bonds in the U.S. posted their worst monthly loss since October 2008 in June as Fed Chairman Ben S. Bernanke said the central bank may start dialing down its $85 billion monthly bond purchasing program this year. The comments sparked declines from bonds to stocks as investors weighed the possibility of an end to easing that’s suppressed borrowing costs and pushed investors into riskier assets.

Europe Crisis

During May and June, relative yields on financial debt increased by 19 basis points, 11 basis points more than the increase in industrial spreads, Bank of America Merrill Lynch index data show.

In the first three months of 2009, bank bonds deepened their slump with their relative yields widening 127 basis points even as industrial spreads contracted by 95, Bank of America Merrill Lynch index data show.

Relative yields on financial notes widened 142 basis points more than industrial spreads in the selloff from May through November 2011 as European policy makers negotiated an accord with Greece’s creditors to avoid a default that threatened to unravel the euro zone.

“The beta has been declining as the credit quality is improving,” Gupta said.

Bank bonds have returned 14.2 percent since the end of 2011, compared with 4.7 percent for industrials in the period, Bank of America Merrill Lynch index data show. Bank debt’s effective duration, a measurement of their sensitivity to rising interest rates, is 4.6 compared with 7.1 on industrial notes.

“We prefer to avoid, as much as possible, exposure to high-quality industrials,” wrote Bank of America credit strategists led by Mikkelsen and Yuriy Shchuchinov in a July 30 report. “We are also long-term overweight financials, and especially life insurance companies and banks as their business models benefit from higher interest rates and the underlying drivers of the rise in rates.”