(Bloomberg) -- Money managers including Invesco Ltd. and Loop Capital Asset Management are bullish on regional-bank bonds, wagering that the debt will perform better than the broader market as fears about funding costs settle down.

Invesco has been loading up on regional-bank bonds during the second half of the year to take advantage of “some really attractive” new issues, said Matt Brill, head of North America investment-grade credit at the firm. Loop Capital has been combing the secondary market for bargains, expecting most lenders to pull through if benchmark rates stabilize and the economy continues to grow, said Scott Kimball, chief investment officer at the firm. 

A string of regional-bank failures earlier this year stoked concerns about lenders, who now face greater regulatory scrutiny, in addition to losses tied to commercial real estate after interest rates have risen. But deposit levels at the banks, which had been shrinking, are showing signs of stabilizing. And investors in recent weeks have grown more hopeful that the Federal Reserve will start cutting rates earlier next year, a hope that Chair Jerome Powell pushed back against Friday. Cutting rates could cut funding costs for the banks, reducing some of the pressure on their earnings.

For investors who think regional banks won’t face as hard of a time as they did this year, it’s a good time to buy the sector’s debt. Spreads for financial institution bonds have tightened around 65 basis points since the banking turmoil in March — signaling recovery — but they’re still nearly 20 basis points wider than that of the broader high-grade index. 

“Overall it feels as if the worst is likely behind them,” Invesco’s Brill said in an interview. “We think they are good credits and give you the ability to somewhat sleep at night.”

While investors have been concerned about the lenders’ exposure to the troubled commercial real estate industry, these worries are probably overblown, said David Knutson, senior investment director at Schroder Investment Management, who considers the sector’s debt attractive at current prices. The Fed has also been keeping close tabs on the issue.

Regional lenders have taken steps to prove their creditworthiness and inspire confidence, according to S&P Global Ratings’ Brendan Browne. They have been strengthening their balance sheets, suspending share buybacks, and their deposits have moderated from peak outflows earlier in the year, according to S&P. While the ratings firm expects profit margins to worsen and credit quality to deteriorate gradually next year across US banks, it still expects relative stability in the sector in 2024.

Some investors are more hesitant to buy the debt. After purchasing cheap bank bonds during the regional-lender turmoil in March, T. Rowe Price Group Inc. has been reducing its exposure to the sector, said Steven Boothe, head of global investment-grade fixed income. He doesn’t think investors are getting enough compensation given the headwinds ahead. 

“We have pretty modest allocation to regional banks and we’ll reassess and reevaluate later next year when they’re forced to issue more bonds,” Boothe said. 

DoubleLine Capital is staying away from regional-bank debt because of worries about the sector’s exposure to commercial real estate. Matt Eagan, co-head of the full discretion team at Loomis Sayles & Co. prefers money-center banks over regionals, and is scouting for opportunities in debt rated BBB and BB.

Moody’s Investors Service lowered its ratings for 10 small and midsize lenders in August and cautioned that more downgrades are coming for regional and community banks. Now, about 40% of US banks  — mostly regionals — that it rates have negative outlooks.

“There’s some probability that we’ll have more downgrades next year,” said Moody’s Allen Tischler. “2024 is going to be a challenge but the banks are readying themselves for it.”

Yet, those who remain bullish expect fundamentals to improve for lenders that had a rough year.

“This is a sector that already trades with a lot of hair on it, so things don’t have to be perfect,” said Bloomberg Intelligence’s Arnold Kakuda. “In a market where the spreads are really tight, this is one sector that still looks cheap.”

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