Fed-Induced Rally Makes Riskiest Debt Priciest: Credit Markets

Tuesday, 26 October 2010 02:17 PM

Oct. 25 (Bloomberg) -- The lowest-rated junk bonds are the most expensive part of the corporate debt market following a Federal Reserve-induced rally in high-risk assets, adding to concern that fixed-income securities are overvalued.

The extra yield investors demand to hold bonds rated CCC or lower issued by companies worldwide instead of government debt is about 10.2 percentage points, or 3.3 percentage points narrower than the average over the past 12 years, according to Bank of America Merrill Lynch index data. Debt with B ratings, at 0.3 percentage point, is the only other part of the market trading tighter than its historical average.

Record-low interest rates in the U.S. and Europe, and speculation the Fed will purchase more bonds to keep the economy from faltering, are encouraging debt investors to take on riskier securities and stoking concern prices are rising to unsustainable levels. Goldman Sachs Group Inc. advised its clients to avoid adding CCC rated debt in a report published Oct. 22 because of slower economic growth.

“With CCCs even more richly valued than historically, the risk of poor relative returns in the future would appear to be high,” said Martin Fridson, a global credit strategist in New York at BNP Paribas Asset Management, who began his career as a corporate debt trader in 1976. “You have to be conscious of that risk of underperformance. Having relatively rich valuations puts investors at a handicap.”

Issuance Surge

The rally in the lowest-rated company bonds has sparked a surge in issuance. MGM Resorts International, the biggest casino operator on the Las Vegas Strip, Energy Future Holdings Corp. and other companies have sold $6.5 billion of bonds this month rated CCC+ or lower by Standard & Poor’s or Caa1 or lower by Moody’s Investors Service, data compiled by Bloomberg show.

That’s the most since April for debt S&P deems “currently vulnerable to nonpayment” and “is dependent upon favorable business, financial, and economic conditions for the obligor to meet its financial commitment.”

Elsewhere in credit markets, banks are marketing more than $4.6 billion of bonds tied to hotel loans. Toll Brothers Inc. said it obtained an $885 million revolving line of credit in a “strong vote of confidence” by its banks. Assured Guaranty Ltd. was stripped of the bond insurance industry’s last AAA ranking.

Bank of America Corp. and Goldman Sachs are selling $2.66 billion of securities backed by debt from the 2007 buyout of Hilton Worldwide in the largest sale of its kind in 2010, according to a person familiar with the offering. JPMorgan Chase & Co. and Deutsche Bank AG are also offering $2 billion of debt tied to Extended Stay Inc., the hotel operator that exited bankruptcy this month, said a separate person, who also declined to be identified because terms aren’t public.

Toll Brothers

“Hotels were the first ones to get rocked and in some respects have the most upside,” said Andrew Parower, a money manager at Marketfield Asset Management LLC, a New York-based firm that runs a $250 million commercial-mortgage backed securities fund. “They got beaten up so quickly and so badly. It’s a leveraged bet on the economy.”

The S&P/LSTA US Leveraged Loan 100 Index rose 0.06 cent to 91.13 cents on the dollar. The index, which tracks the 100 largest dollar-denominated first-lien leveraged loans, reached 91.14 cents on Oct. 14, the highest in five months.

Toll Brothers’ four-year facility replaces a $1.89 billion revolver that was set to expire in March 2011, the Horsham, Pennsylvania-based company said in a statement. The new credit line can be increased to as much as $2 billion.

Assured Cut

“This is the first new unsecured credit facility completed by a publicly traded home building company since the financial crisis of 2008,” Martin P. Connor, chief financial officer at Toll Brothers, said in the statement. “We believe this transaction is recognition by the banking community of the prudent manner in which we have navigated these difficult economic times, and, more importantly, is a strong vote of confidence in our future.”

S&P cut Assured, backed by billionaire Wilbur Ross, as investors and issuers wean themselves from the guarantees offered by insurers. The New York-based ratings company reduced its financial strength and counterparty credit rating on Assured Guaranty Corp. and Assured Guaranty Municipal Corp. one level to AA+, according to a statement today.

The AAA ratings held by the units before the move were the last for a bond insurer after guarantors from MBIA Inc. to Ambac Financial Group Inc. were removed of the rankings in 2008 amid a housing crisis that saddled them with potential losses from mortgage-related bets.

Protecting Debt

The cost of protecting corporate bonds from default in the U.S. fell to the lowest in more than five months. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses on corporate debt or to speculate on creditworthiness, declined 3 basis points to a mid-price of 93.3, as of 5:06 p.m. in New York, according to index administrator Markit Group Ltd.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings declined 3.7 to 95.7, the lowest since Oct. 13.

Credit swap indexes typically fall as investor confidence improves and rise as it deteriorates. Contracts 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.

Bonds from Bank of America, based in Charlotte, North Carolina, were the most actively traded U.S. corporate securities by dealers today with 87 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

‘Volatile Part’

Goldman Sachs said bonds rated CCC+ and lower by S&P or Caa1 by Moody’s were “expensive” given expectations for economic growth, and recommended clients buy higher-ranked company bonds instead. John Lipsky, the No. 2 official at the International Monetary Fund, said last month that global economic growth in the second half of the year will fall short of the fund’s forecast of 3.75 percent on an annualized basis.

“You don’t want to stand in the way of the search for yield,” said Alberto Gallo, a global credit strategist at Goldman Sachs in New York. “But on the other hand it is a very volatile part of the market. And it can be particularly sensitive to a further slowdown in the economy.”

Yields on U.S. investment-grade debt fell to a record low of 3.55 percent this month, the lowest borrowing cost on record in data going back to October 1986, according to Bank of America Merrill Lynch index data. For CCC bonds and lower, yields dropped to 11.66 percent on Oct. 15, the lowest level since November 2007, Bank of America Merrill Lynch data show.

Fed Injects

Average spreads on the debt have narrowed to 10.2 percentage points from as high as 11.8 percentage points in June and a record 45.6 percentage points in December 2008, according to Bank of America Merrill Lynch index data. Debt in the B range pays a spread of 6.07 percentage points, or 0.3 percentage point less than their average over the past 12 years. Investment-grade securities pay a premium of 8 basis points to 31 basis points over their longer-term averages.

Investors are paying ever-higher prices on speculation that the money the Fed injects into the economy will allow the neediest borrowers to refinance the more than $815 billion of loans and bonds that Bank of America Merrill Lynch estimates comes due through 2015. JPMorgan analysts predicted in a report this month that the high-yield default rate for bonds will fall to 1.4 percent next year, compared with the 6 percent implied by bond yields.

MGM Sold

Of the junk-rated bonds sold in the U.S. this year, 16.2 percent are from issuers rated CCC by at least one ratings firm, up from 10.7 percent in 2009, according to JPMorgan. That’s still below the 25 percent average over the five years ended in 2008, the firm said in an Oct. 22 report.

MGM sold $500 million of six-year notes at a yield of 10.25 percent to repay lenders under its senior credit facility, Bloomberg data show. Covenant Review LLC, a debt research firm, said in a report that Las Vegas-based MGM is offering investment-grade type covenants even though the bonds will be junk-rated, including no restrictions on the company’s ability to incur debt, make dividends, or sell assets.

The offering, along with the sale of stock and certain assets, should address all of MGM’s bank debt maturities in 2011, according to KDP Investment Advisors Inc., a Montpelier, Vermont-based debt research firm.


Dallas-based Energy Future, known as TXU Corp. before KKR & Co. and TPG Capital paid $43.2 billion for the electricity provider in 2007, raised $350 million on Oct. 15 in an offering of second-lien notes due in April 2021 yielding 15 percent.

Securities rated CCC and lower have returned 16.4 percent this year, after gaining 101 percent in 2009. This year’s returns compare with 15.3 percent for debt ranked BB and 12.7 percent for B bonds. Debt rated BBB has gained 11.4 percent, the best among investment-grade bonds.

“We’re in a scenario where there is a desperate need for yield,” said Gary Jenkins, head of fixed-income at Evolution Securities Ltd. in London. “Corporates are almost seen as a quasi-safe haven. It won’t be the case if the economy turns negative, double dip-like.”

The lowest-rated bonds are “quite rich” by historical standards partly because hedge funds that rely on debt to boost returns have become bigger players in the market and don’t care as much whether the spread compensates for default risk, according to Fridson.

“I had thought the downturn would either blow away some of the leveraged players or at least induce them to tighten up their risk management,” he said. “That has not happened.”

Riskiest Junk

Money managers are piling into the riskiest junk bonds and taking ever-lower yields and spreads because they face a lack of alternatives. Investments on everything from government debt to corporate bonds are paying some of the lowest coupons on record as the Fed holds its target overnight lending rate between banks in a range of zero percent to 0.25 percent since December 2008. The European Central Bank’s main refinancing rate has been at a record-low 1 percent since May 2009.

“The low government yield environment is squeezing investors into riskier assets, which I suppose is partly what the Fed wants,” Jim Reid, head of fundamental strategy at Deutsche Bank AG in London, said in an Oct. 25 note to clients. “It remains a gamble though, as if it doesn’t feed into the economy it will eventually leave a bigger gap between asset prices and the fundamentals.”

--With assistance from Sarah Mulholland, Tim Catts, Sapna Maheshwari and Richard Bravo in New York. Editors: Paul Armstrong, Pierre Paulden

To contact the reporter on this story: Bryan Keogh in London at bkeogh4@bloomberg.net

To contact the editors responsible for this story: Paul Armstrong at parmstrong10@bloomberg.net

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Oct. 25 (Bloomberg) -- The lowest-rated junk bonds are the most expensive part of the corporate debt market following a Federal Reserve-induced rally in high-risk assets, adding to concern that fixed-income securities are overvalued. The extra yield investors demand to hold...
Tuesday, 26 October 2010 02:17 PM
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