By Jennifer Ablan

Even as bank shares come under severe pressure as the companies slash dividends and undertake dilutive capital-raising, bondholders of the major financial companies expect to benefit tremendously as the increased equity capital and lower dividend payouts improve the companies' credit quality.

Gross said in an interview that he continues to hold the "high-quality" debt of banking companies because they represent good long-term value.

Gross, chief investment officer at Pacific Investment Management Co, known as Pimco, told Reuters that, in addition to Citigroup, he remains a holder of the debt of Morgan Stanley , Goldman Sachs Group Inc , Deutsche Bank , and Spain's Banco Santander .

Gross -- who manages the $130 billion Pimco Total Return Fund -- joins other big bond managers, including Dan Fuss, vice chairman of Boston-based Loomis Sayles, in buying and holding onto the corporate credits of major investment banks.

Recently, Fuss, who helps oversee more than $100 billion in fixed-income securities, had been purchasing the debt and convertible preferred securities of Lehman Brothers .

The bets by Fuss and Gross on banks' corporate debt has been paying off. The Merrill Lynch U.S. corporate finance index is trading at a spread of 287 basis points over comparable Treasuries, narrowing dramatically from 333 basis points at the end of March and from 341 basis points during the Bear Stearns saga.

"Dividend cuts, dilutive capital raises, deleveraging, lower revenues and earnings is a horrible equity story, but is not so terrible for bondholders," said Greg Peters, head of global credit strategy at Morgan Stanley in New York.

Since last year, exposure by financial institutions globally to subprime mortgage debt and structured finance products has resulted in more than $400 billion of write-downs and losses. That has led financial institutions to raise capital and cut dividends.

"The increased capital raising and less dollars going to dividends is a classically bondholder friendly event," added Peters.

It's another story for equity investors, of course.

The Philadelphia KBW Bank Index of 24 large banks -- which includes Citigroup -- dropped to its lowest since October 2002 on Wednesday, weighed down by sharp losses among regional banks, the latest sector to run into trouble in the deepening housing and credit crises.

The deleveraging process will continue to be painful, Gross said. "The financial system is deleveraging, which noticeably affects financials, but ultimately reflects negatively on our entire economy since it is finance- and consumption-oriented," he said.

Export-driven sectors are "holding up the rest of the market," Gross said. But he quickly added that export-driven economies are vulnerable if developing economies continue to tighten policies by way of higher interest rates and currency revaluations.

"Oil, of course, is not helping matters," he added.

(Editing by Leslie Adler)