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Riskiest Bonds Are Haven as Fed Seeks Inflation

Sunday, 21 Nov 2010 06:14 PM

The riskiest junk bonds are providing a refuge for investors concerned that inflation will accelerate as the Federal Reserve attempts to bolster the economy.

Debt issues from iStar Financial Inc., the commercial real- estate lender, and Atlanta-based credit-card processor First Data Corp. are leading returns of 0.22 percent this month for bonds rated CCC and lower, while higher-ranked BB tier debt is down 0.76 percent, Bank of America Merrill Lynch index data show. Investment-grade debt losses average 1.15 percent.

The lowest-tier notes offer yields of about 11.5 percent, compared with 6.4 percent for BB bonds, providing a buffer in case consumer prices rise at a faster pace as the Fed prints money to buy $600 billion of Treasuries. When inflation accelerated in 2006, returns on the CCC bonds were 18.6 percent, almost double the 9.9 percent gain for BB debt and 4.64 percent for high-grade securities.

“The wider the spread the more cushion you have” against rising consumer prices eating into interest payments, said James Serhant, senior vice president and head of high-yield fixed income at Hartford Investment Management Co. in Hartford, Connecticut, who oversees the $448.6 million Hartford High Yield Fund.

Holding Value

Issuance of the lowest-rated debt is accelerating, with $8 billion CCC or lower bond offerings in November, following $9.7 billion in October, the most since the credit crisis began in 2007, according to JPMorgan Chase & Co. Sales this year of $45.8 billion of the debt are surpassed only by the record $52 billion issued in 2007, JPMorgan analysts led by Peter Acciavatti in New York wrote in a report dated Nov. 19.

Concern that inflation may quicken is also arising in the market for government-backed mortgage bonds, leading buyers to seek securities filled with loans with higher rates, Barclays Capital index data show.

Elsewhere in credit markets, relative yields on corporate bonds worldwide fell last week, reversing the previous period’s increase. The cost of protecting company debt from default in the U.S. and Europe declined. Loan prices dropped after rising for three straight weeks. In emerging markets, spreads widened for a second week.

Yields on company debt from the U.S. to Europe and Asia narrowed 2 basis points relative to government bonds last week to 165 basis points, or 1.65 percentage points, according to Bank of America Merrill Lynch’s Global Broad Market Corporate Index. Spreads are up 1 basis point this month. Yields last week rose to an average 3.67 percent from 3.58 percent.

Default Swaps Decline

Credit-default swaps on the Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, fell 4.3 basis points last week to 89.33 basis points, according to Markit Group Ltd. That’s the lowest level since Nov. 8.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings declined 3 to 100.5, the biggest drop since the week ended Oct. 8, when the benchmark fell 7 basis points.

The indexes typically fall as investor confidence improves and rise as it deteriorates. Swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Sales Slow

Global corporate bond sales declined 38 percent last week to $74.5 billion, according to data compiled by Bloomberg. Wind Telecomunicazioni SpA, the Italian mobile-phone company whose parent is merging with VimpelCom Ltd., sold $3.69 billion of notes in dollars and euros in the biggest offering of high- yield, high-risk debt in Europe in a year.

The Standard & Poor’s/LSTA US Leveraged Loan 100 Index fell 0.38 cent to 92.01 cents on the dollar, the lowest since Nov. 5. Prices on the index, which tracks the 100 largest dollar- denominated first-lien leveraged loans, have declined from 92.72 cents on Nov. 9, the highest since May 3.

In emerging markets, relative yields rose 6 basis points to 244 basis points, according to JPMorgan index data. Spreads have widened 2 basis points since the end of October.

The least creditworthy borrowers are attracting yield- starved investors as Fed Chairman Ben S. Bernanke seeks to reduce unemployment, at 9.6 percent last month, and avert deflation by keeping interest rates at record lows. The U.S. central bank has maintained its benchmark rate in a range of zero to 0.25 percent since December 2008 following the worst financial credit crisis since the Great Depression.

Consumer Prices

The consumer-price index increased 0.2 percent in October after a 0.1 percent rise the prior month, the Labor Department said Nov. 17 in Washington. Excluding food and fuel, so-called core costs increased 0.6 percent from October 2009, the smallest gain on record.

Fed officials don’t seek inflation higher than the level of “2 percent or a bit less” that most policy makers see as consistent with the bank’s legislative mandate, Bernanke said in Frankfurt on Nov. 19. Inflation has slowed since the most recent recession began in December 2007, and “further disinflation could hinder the recovery,” he said.

Bonds paying about 10 percent will hold their value better than those paying 6 percent, said James Lee, a fixed-income analyst at Calvert Asset Management in Bethesda, Maryland.

“The question is, ‘Are you getting compensated enough for CCC risk?’” said Lee. “The answer is ‘Probably.’ They’re probably fully valued.”

iStar, First Data

Bonds from New York-based iStar have returned 6 percent this month, while debt from First Data, acquired by KKR & Co. three years ago, has gained 5.23 percent, according to Bank of America Merrill Lynch’s US High Yield, CCC and Lower Rated Index.

A return of 1.2 percent from Plano, Texas-based J.C. Penney Co., the third-largest U.S. department-store company, led the Bank of America Merrill Lynch US High Yield, BB Rated Index.

The lower-rated index gained 3.54 percent in October, compared with 2.04 percent for the BB bonds, following CCC returns of 3.8 percent in September, versus 2.74 percent.

High-yield, high-risk debt is rated below Baa3 by Moody’s Investors Service and lower than BBB- by S&P.

Concern that lower-coupon government-backed mortgage securities will remain outstanding for longer as borrowing costs rise is among “the most likely culprits” responsible for a jump in volatility in that market, Citigroup Inc. analysts Brad Henis and Inger Daniels in New York wrote in a Nov. 19 report.

Refinancing Risk

Higher rates reduce refinancing among the underlying mortgages, creating so-called extension in the lives of the bonds that means holders must wait longer to get their principal back as new investments offer higher yields. Lower-coupon debt is now more sensitive to the dynamic because refinancing and defaults by borrowers with higher-rate loans will be less affected by higher new-mortgage costs.

Agency mortgage bonds with 3.5 percent coupons, with estimated durations as of Nov. 18 of 4.73 years, underperformed similar Treasuries by 21 basis points this month through that date, Barclays data show. Securities with 5.5 percent coupons and 2.97-year durations outperformed by 65 basis points. Duration is a measure of the securities’ price sensitivity to yield changes.

The lowest-rated corporate borrowers are using bond offerings mostly to refinance debt, according to the JPMorgan report. Of this year’s $46 billion of CCC issuance, 69 percent was for refinancing, compared with 9 percent of the $52 billion sold in 2007.

Defaults have declined as companies gained access to cheaper debt. The 12-month trailing default rate on U.S. speculative-grade corporate bonds declined for an 11th straight month in October, to 3.37 percent from 3.96 percent in September, S&P analyst Diane Vazza wrote in a Nov. 19 report.

The lowest-rated bonds typically have shorter durations. Notes ranked CCC and lower have durations averaging 3.35 years, compared with 4.89 years for BB notes, Bank of America Merrill Lynch data show.

“You’re exposed to greater price risk as interest rates rise” with the longer-duration debt, said Edward Mally, director of fixed income research at Imperial Capital LLC.

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The riskiest junk bonds are providing a refuge for investors concerned that inflation will accelerate as the Federal Reserve attempts to bolster the economy.Debt issues from iStar Financial Inc., the commercial real- estate lender, and Atlanta-based credit-card processor...
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2010-14-21
 

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