Credit Quality at U.S. Banks Shows Continued Improvement

The Federal Reserve last week released the results from its now infamous “stress tests,” where large U.S. banks are tested for how they would perform in a recessionary U.S. economic scenario and under stressed financial system conditions.  The goal of the tests is to measure capital levels at banks should a deep recession with a rising unemployment rate, a steep drop in housing prices and a 50% decline in the stock market occur.  While losses under these scenarios would be significant, 29 of the 30 largest U.S. banks would maintain a “Tier-1 common capital ratio,” a measure of balance sheet strength, of at least 5%. The lone bank to fail the test, Zions Bancorporation, will likely be denied the opportunity to return capital to shareholders via dividends and share buybacks.  These tests validate the fundamental credit work we’ve done on U.S. banks and provide further support of our overweight position in the sector as credit quality has consistently improved over the last several years. Bank bonds have outperformed the broad corporate market during that time frame, and we believe they have further room to run as the market continues to recognize the capital improvements and risk reduction measures banks have implemented.