Basel II could have a major impact on the bond markets, according to a new report from Morgan Stanley. The report, Basel II – Impact on Spreads, argues that banks are likely to increase their bondholdings as a result of their assumed rate of return increasing 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 more likely to buy fixed-income assets in general than equities.
The assumed rate of return will increase on large sections of European banks’ fixed-income holdings under the new regime. Since banks are among the major buyers of bonds – they typically make up about 25% of the market for triple-B rated corporate new issues – 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 €10 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. It bases its assumptions on the likelihood that most banks will implement the Foundation IRB (internal ratings-based) approach from day one.
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 10.05%, which means more banks will be attracted to this grade.
The report uses Marks & Spencer to illustrate how a triple-B rated corporate borrower will be affected. For a bank using the Foundation IRB approach, the ROE on Marks & Spencer bonds will rise from 12.3% under Basel I to 30.7% under Basel II.
The report points out that since the market is now in a tight spread environment, and 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 normalised spread environment [will] amplify the asset reallocation process of banks”.