Investors are demanding higher yields to own the bonds of regional banks, threatening to further pressure lenders already being hit by rising deposit costs.

The extra yield, or spread, on regional-bank bonds over U.S. Treasurys had risen in many cases by about two percentage points or more since early March, when the failures of Silicon Valley Bank and Signature Bank spurred a broad investor retreat from all but the largest U.S. banks.

The spread widening is based on a sampling of actively traded bonds of lenders with about $150 billion to $220 billion of assets, such as Columbus, Ohio-based Huntington Bancshares, and Buffalo, N.Y.-based M&T Bank. Banks in that group are small enough that concerns have emerged about their health but still large enough to have significant amounts of bonds outstanding.

By contrast, the spread on 10-year JPMorgan Chase bonds increased by only around 0.1 percentage point over that span, reflecting in part the firm's financial strength and the perception that the U.S. wouldn't allow a bank so large to fail.

After the bank failures in March, federal regulators have signaled that they eventually could force banks with as little as $100 billion in assets to issue more long-term bonds, subjecting them to similar requirements as the giant banks now deemed systemically important.

Such rules create a buffer of debt that can be converted into equity if a bank becomes insolvent, reducing the need for taxpayer-funded bailouts. But the impact for regional banks could be selling bonds into a market that isn't eager to purchase them.

Higher yields on regional-bank bonds won't immediately translate to higher borrowing costs for regional lenders. Their eventual impact could also be modest, given that regional banks would be overwhelmingly funded by deposits rather than bonds even after new regulations are applied.

But higher borrowing costs drag on midsize banks, especially when many already have to increase deposit rates to hold onto customers.

Many investors and analysts, meanwhile, say that regional-bank bonds are oversold, noting that most banks have reported relatively stable deposit levels despite the recent market turmoil.

As of Tuesday, Huntington's 5.023% bonds due in 2033 were trading at just under 90 cents on the dollar, translating to a roughly 6.6% yield and a spread to Treasurys of around 3.1 percentage points, up from about 1.7 percentage points before Silicon Valley Bank's failure. Its more actively traded 4% notes due in 2025 were trading at an even larger spread of almost four percentage points. Bonds of its peers, such as M&T Bank and Providence, R.I.-based Citizens Financial, have been trading at similar levels.

Mr. Arbesman of Neuberger said he thinks there is a chance that spreads on regional banks will eventually return to where they were before Silicon Valley Bank's failure. Having covered banks through different crises, including the housing bust of the late 2000s, Mr. Arbesman said the current situation amounts to "one of the biggest gaps between perception and reality in the sector's history."

Still, even analysts who have been bullish on regional-bank bonds caution that perception could ultimately shape the fundamentals for lenders.

Jesse Rosenthal, a senior analyst at CreditSights who strongly recommended buying regional-bank bonds, said that banks continue to "look very, very solid."

He said, "If the sentiment continues to be so bad that we start to see a new round of massive deposit outflows, that will create a problem for the best-run bank."

Key Points

  • Investors are demanding higher yields to own the bonds of regional banks.
  • The spread on regional-bank bonds over U.S. Treasurys has widened by about two percentage points since early March.
  • The widening spread is due to concerns about the health of regional banks and the prospect of new regulations that could force them to issue more long-term bonds.
  • Higher borrowing costs could pressure regional banks, especially those already facing rising deposit costs.
  • Some analysts believe regional-bank bonds are oversold, and the spread could narrow.
  • However, others caution that perception could ultimately shape the fundamentals for lenders and that a new round of massive deposit outflows could create problems for even the best-run bank.

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