A report from Morgan Stanley has demonstrated precisely how great the impact of Basel II will be on demand for corporate bonds and securitization. Ever since the wording of Basel II was completed and published in June this year, it has been obvious that the legislation will encourage banks to invest in bonds over equity and investment grade over junk. But the scale of that incentive has not been apparent until now.
Morgan Stanley calculates that a bank's rate of return on equity under Basel II for A-rated corporate bonds will increase from 4.09% to 10.05%, while the return on C-rated bonds will decrease from 40.27% to 14.88%. The change in the return on securitization is even more pronounced, with A-rated commercial mortgage-backed securitization leaping from 4.24% to 57.57%.
A bank's rate of return will increase for bonds and for better-rated issuers because under Basel II it will have to put aside more capital to cover itself against riskier investments. The bank will effectively pay more for equity and for junk bonds because it will have to put aside greater capital as a result.
As banks and bank funds account for a large proportion of demand for corporate bonds in Europe ? 42% of demand for notes from A-rated corporates and 80% of all collateralised debt obligations ? any shift between asset classes would have a heavy impact on spreads, making issuing bonds cheaper generally, and particularly for investment grade companies.