Companies Not Shying From Hard-To-Sell Junk Debt

Bloomberg

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Bond investors are losing their aversion to difficult-to-trade corporate debt that handed them some of the biggest losses in the credit crisis.

The extra yield note buyers demand to own older, smaller junk bonds that trade infrequently has shrunk to an average 0.25 percentage point this month from more than 1 percentage point a year ago, according to Barclays Plc data. JPMorgan Chase & Co. money manager Jim Shanahan said he's preferring "good credit quality and less liquidity" when picking bonds, while Howard Marks, the head of distressed debt investor Oaktree Capital Group LLC, said he's finding bigger potential gains in private, less-traded debt.

The evaporating premium for illiquid assets is showing the depths to which money managers are reaching to boost returns after a five-year rally that pushed relative yields on junk bonds to the least since August 2007. With Federal Reserve monetary policies suppressing interest-rate benchmarks for a sixth year, credit buyers are showing more concern that they'll miss out on a continued rally than get stuck with debt that lost 26 percent during the market seizure in 2008.

"For the past several years, people have been concerned about liquidity," said Eric Gross, a credit strategist at Barclays in New York. "Now we're hearing more about people seeking out illiquid bonds."

Fragile Market

Such debt tends to be more vulnerable to price swings when market sentiment deteriorates, because there are fewer buyers to bid on it when investor withdrawals force money managers to sell. Those risks intensified after stricter banking rules accelerated a pullback by Wall Street dealers that used their own money to facilitate trading.

Primary dealers that trade directly with the Fed cut their holdings of corporate bonds by 76 percent to $56 billion after peaking at $235 billion in 2007, Fed data through March show. After the central bank changed the way it reported the holdings in April, net speculative-grade bond holdings fell as much as 24 percent to a low of $5.63 billion in May before rising to $7.7 billion on Jan. 8.

Investors are demanding an average yield of 5.94 percent to own bonds sold at least 18 months ago in batches of less than $250 million, Barclays data show. That compares with an average 5.7 percent for newer debt offerings of at least $500 million. The gap, which averaged 0.5 percentage point last year and 0.92 percentage point in 2012, reached as much as 1.95 percentage points at the peak of the financial crisis in March 2009.

The yield on MGM Resort International's $238 million of 6.875 percent notes, which were issued in 2006 and mature in April 2016, has dropped 2.4 percentage points during the past year to 1.85 percent, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. That compares with a decline of 0.5 percentage point to 5.4 percent on the casino owner's $1.25 billion offering of nine-year, 6.625 percent securities in December 2012.

"As people continue to look for yield and performance, they're willing to move into less-liquid areas of the market," said Shanahan, who manages high-yield credit investments for JPMorgan's $1.5 trillion asset management unit. "You're seeing a classic market cycle of people looking for pockets of value."

'Intoxicating Brew'

With corporate borrowers selling record volumes of debt to lock in all-time low yields amid global central bank stimulus, "there is a tremendous and potentially unsustainable amount of paper in investors' hands, and this harsh reality is causing much angst," according to a McKinsey & Co. and Greenwich Associates report in August.

Federal Reserve Bank of Dallas President Richard Fisher, a former managing partner of a fund that bought distressed debt, said in a speech last week that he'd "have to hire Sherlock Holmes to find a single distressed company priced attractively enough to buy."

Five years after the Fed started holding benchmark rates at about zero and pumping more than $3 trillion into the financial system to ignite growth, Fisher warned in the Jan. 14 remarks to the National Association of Corporate Directors that signs are emerging that Fed stimulus has made for "an intoxicating brew."

Even as the central bank starts slowing monthly bond purchases to $75 billion from $85 billion, yields on dollar-denominated speculative-grade bonds have fallen to 6.21 percent, 0.22 percentage point from the record low in May 2013, according to Bank of America Merrill Lynch index data.

The securities, which provide bigger cushions of extra yield over benchmark rates than higher-rated debt, are governed by idiosyncratic deal documents and aren't as frequently traded. While trading in speculative-grade bonds has risen, volumes have failed to keep pace with a market that's expanded 71 percent since 2008 as Wall Street's biggest banks reduce their holdings of riskier assets in the face of new regulations.

Speculative-grade, or junk, bonds are rated below Baa3 by Moody's Investors Service and lower than BBB- at Standard & Poor's.

Investors are emboldened by a U.S. economy that will probably expand by 2.8 percent this year and 3 percent in 2015 from 1.9 percent in last year, according to a Bloomberg survey of 83 economists. High-yield bond funds have received $3.85 billion of deposits since the end of September, according to data compiled by Royal Bank of Scotland Group Plc, as investors gained conviction that the U.S. economic recovery was strengthening. The unemployment rate dropped to 6.7 percent by Dec. 31 from 10 percent in October 2009.

More Homework

"Money has found it very easy to flow into public, mainstream things," said Marks, Oaktree's chairman, in a Dec. 10 presentation for investors. "The best credit opportunities are in niche markets."

He said the firm is earning about 11.5 percent to extend loans to smaller companies, about twice as much as the yield on a junk bond of comparable quality.

These deals are small and "entirely illiquid," he said. "It requires a lot of due diligence."

Publicly traded business-development corporations, which lend to the smallest and riskiest companies, attracted $4.1 billion last year, the most since 2007, as the firms known as BDCs gained an average 16.4 percent. The firms are juicing returns by borrowing about 50 cents for every dollar raised from equity investors, up from 36 cents in 2011, according to data compiled by Keefe, Bruyette & Woods analysts.

BDCs and other alternative asset managers that lend to small and mid-sized companies are filling a role traditionally dominated by banks, J.P. Morgan Asset Management's Shanahan said in a telephone interview. Holding smaller, less-traded securities can boost investor returns while maintaining a higher level of credit quality, he said.

"Credit is good and likely to be good over the horizon," he said. "People become less concerned about liquidity as you're less likely to need it in the near term."

Elsewhere in credit markets, the cost to protect against losses on U.S. and European corporate bonds jumped to the highest in five weeks. La Banque Postale SA is turning to the covered bond market to fund its mortgage business that has grown by about 50 percent over the past four years and can no longer be financed solely by customer deposits.

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