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Scariest thing in U.S. bond markets? Interest rate stability

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The scariest thing in the bond markets is no longer the stability of banks, but the stability of interest rates because of the possibility that the Federal Reserve will slow its bond purchases. It is not too surprising, then, that markets have shrugged at the latest suggestion that bonds of systemically important banks may not carry an implicit government guarantee.

Last week Standard & Poor's said it may no longer factor government support into ratings for the holding companies of the biggest U.S. banks. The assumption of support is worth a one or two-notch boost. A two-notch hit would take the holding companies of Citigroup Inc., Bank of America Corp., Goldman Sachs Group Inc. and Morgan Stanley to just two grades above junk. A-rated JPMorgan Chase & Co. receives a one-notch "too big to fail" lift from S&P on the holding company. Operating companies are still likely to be bailed out, S&P figures. But most bank debt is issued at the holding company level.

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This idea is not new. Regulators are considering mandating minimum amounts of long-term debt at bank holding companies – that is, a non-taxpayer funded buffer against losses. Moody's had already signalled concerns similar to S&P's. Moody's analysis could take the Citigroup and Bank of America holding companies to junk. And, there are also real world examples: losses were forced on junior bondholders at Dutch bank SNS Reaal when the bank foundered.

U.S. bank bond spreads have widened recently but corporate spreads have, too. After years of deleveraging and stress testing, bank bonds have started to look rather safe. Earlier this year, bank bonds on average traded at their lowest premiums to treasuries since 2007. Yields on average for financial company debt are about 2.7 per cent, according to Barclays. But as overall rates rise, borrowing costs become a more pressing issue, especially if regulators decide what kind of debt banks must issue.

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