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Basel II Expected to Boost Bank Bond Holdings (November 29, 2004)

Location: London
Author: Ellen J. Silverman
Date: Monday, November 29, 2004

Basel II could have a major impact on the bond markets, according to a new report from Morgan Stanley titled, "Basel II - Impact on Spreads". Morgan analysts argue that banks are likely to increase their bond holdings since the rate of return is expected to increase under Basel II. This is because Basel II links economic risk to the amount of regulatory capital that needs to be set aside to cover it. Banks will be more likely to buy highly rated bonds than sub-investment grade and buy fixed-income assets over equities.

The assumed rate of return will increase for European banks' fixed-income holdings since banks are among the major buyers of bonds and any shift in their buying patterns could have a huge impact on the market as a whole. The Morgan Stanley report says European banks have over $13 trillion in risk-weighted assets, "so even if they are investing a tiny proportion of this in the fixed-income markets, it's still enough to move spreads." The report says banks are likely to begin rebalancing their portfolios by early 2006 in preparation for Basel II implementation.

The report looks at the likely return on equity (ROE) of a range of fixed-income assets based on the likely risk weightings under Basel II. In the case of corporate bonds, those rated single-A will benefit most from Basel II. Triple-Bs will also see their ROE more than double, but double-Bs stay the same and single-Cs deteriorate. Relatively speaking, single-A rated bonds improve more than triple-Bs, but in outright terms triple-Bs will rise to an ROE of roughly 10%, which means more banks will be attracted to this grade.

The report points out that since the market is now in a tight spread environment, there are unlikely to be significant shifts in asset allocation until the end of next year or early in 2006. It is likely that "a more normalized spread environment will amplify the asset reallocation process of banks".
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