As the following reports illustrate, there's a wild feeding frenzy taking place in the fixed-income markets, especially those involving the riskiest kinds of securities. Call me a cynic, but how does this not end badly?
Seeking safety, inexperienced investors have poured record volumes of assets into bond funds. That's risky—especially if interest rates rise
According to TrimTabs Investment Research, investors poured $467.2 billion into bond mutual funds in 2009 and a further $115.8 billion so far this year. By contrast, an average of $43 billion flowed annually into bond funds from 2003 to 2008.
"It's a bond fund bubble," says Marilyn Cohen, chief executive of Envision Capital Management in Los Angeles and author of the book Bonds Now!: Making Money in the New Fixed Income Landscape. Most of these new fund owners are "unsophisticated investors" who are unaware how much rising rates can hurt bonds, she says. (Because institutions and wealthy investors tend to buy securities directly, mutual fund customers tend to be retail investors.) "If we get a big spike in rates, there will be a mass panic," Cohen says.
Companies sold $33.7 billion of junk bonds in April, a record for the month, with borrowers rushing to issue debt before investors pull back from the riskiest securities as governments struggle to manage their deficits.
High-yield, high-risk offerings were the most since 2006, when $12.9 billion was sold, data compiled by Bloomberg show. Moody’s Investors Service says issuance may rise 10 percent this year, while investment-grade drops 7 percent. OnCure Holdings Inc., a manager of radiation oncology treatment centers, and American Petroleum Tankers LLC, an affiliate of Blackstone Group LP, are among companies planning to sell junk bonds.
While issuance soars and cash streams into the market, cracks are developing. Yields on speculative-grade debt rose last week relative to government bonds for the first time since the period ended Feb. 26, according to Bank of America Merrill Lynch Index data. The rise underscores concern that Europe’s growing fiscal crisis and an investigation into Goldman Sachs Group Inc. may slow the economy.
Junk bonds are making up the biggest share of corporate debt sales on record as investors wagering on an economic rebound snap up securities from even first-time issuers.
Global high-yield bond sales reached $91.7 billion this year, or 12 percent of total issuance, almost double last year’s share, according to data compiled by Bloomberg. Yields on the debt fell to within 5.83 percentage points of Treasuries this week, about the lowest since December 2007 and down from 6.66 percentage points at the end of 2009, Bank of America Merrill Lynch’s Global High Yield Index shows.
Economists are boosting growth forecasts this year, and borrowing costs have fallen to pre-credit crisis levels, reducing default risks. Radiation Therapy Services Inc., the Fort Myers, Florida-based operator of cancer-treatment centers, plans to raise $310 million in its inaugural bond offering, while American Residential Services LLC is selling its first notes in 13 years, Bloomberg data show.
“Most of the major concerns seem to be gone,” said James Lee, a fixed income analyst at Bethesda, Maryland-based Calvert Asset Management, which manages about $15.5 billion. “It’s a self-fulfilling cycle. Cash is coming into high-yield and high- yield managers are putting cash to work,” helping borrowers rollover their debt, he said.
“Companies are trying to come in before the market dries up,” said Kingman Penniman, president of KDP Investment Advisors, a high-yield research firm in Montpelier, Vermont. “It’s an issuers’ market.”
Junk bonds are poised for a 14th straight monthly gain as investors seek riskier assets while interest rates are at record lows. Federal Reserve officials are searching for signs of self- sustaining growth before beginning to exit the most aggressive monetary policy in history. That’s helping borrowers including Ford, the only one of the three largest U.S. automakers to avoid bankruptcy, to sell a record $70.1 billion of high-yield bonds this year, Bloomberg data show.
“The health of the high-yield market is very strong,” said Ann Benjamin, a money manager who helps oversee $7 billion in high-yield debt for Neuberger Berman LLC in Chicago. “The Fed has a zero interest-rate policy that is forcing investors into areas where they can collect a reasonable spread over Treasuries.”
Companies may increase borrowing to pay shareholder dividends in a record year for junk bonds, Standard & Poor's said.
Western European firms sold about 11.7 billion euros ($15.8 billion) of high-yield bonds this year, compared with 36.7 billion euros in all of 2009, according to S&P. Among borrowers, British budget clothing retailer Matalan Ltd., raised 300 million pounds ($461 million) of loans and 225 million pounds of bonds, part of which were used for a shareholder payout.
"We are starting to see the proceeds of high-yield issues being channeled to shareholders as dividends, something that is less-welcome from a credit perspective, reminiscent of the leveraged finance market back in 2007," analysts led by Taron Wade wrote in a report released today.
Companies owned by LBO firms in 2007 issued a record 6.1 billion euros of loans in the first half to pay dividends to shareholders, data compiled by Fitch Ratings show.
Private-equity firms "essentially decreased the risk of their portfolio equity investments, boosting their near-term equity returns at the expense of the credit quality of the companies themselves," according to S&P.
"Junk Has Never Looked so Good" (Financial Times)
The high-yield, or “junk” bond markets have never been in better fundamental or technical shape – and currently offer the best risk/reward trade to be found anywhere, believes Thomas Becket, chief investment officer at PSigma Investment Management.
“Corporate bonds were the ‘hot’ trade of 2009 and the huge interest in these markets has, amazingly, driven the borrowing costs of some high quality companies below those of governments – offering no further value,” he says.
“But yields on junk bonds are much more attractive and there remains the potential for capital gains in the years ahead as the pace of corporate defaults slows.”
Mr Becket says that rating agency projections for ongoing defaults are now overly bearish, having been far too bullish when markets were set to suffer between 2007 to 2009. He expects a high-yield default rate of only about 2 per cent in 2010.
"Rally Has Junk Trading at Close to Face Value" (Financial Times)
Prices of junk bonds have rallied so strongly over the past year that a key market benchmark suggests that they are collectively trading at near 100 per cent of face value, a level not seen since before the credit crisis took hold in 2007.
US junk bond prices, measured in a Bank of America Merrill Lynch index, last week reached a price of 99.55, the closest it has been to par – that is 100 per cent of face value – since June 2007.
That marks a sharp recovery in investor confidence in junk bonds – the borrowings from companies below investment grade – from a nadir struck on December 12, 2008, when the index hit a record low of 54.78.
“The return close to par is symbolic,” said Martin Fridson, chief executive of Fridson Investment Advisors, which specialises in high-yield bonds.
“With the strengthening of the US economy and signs accumulating of revival in consumer demand, money is coming out of money market funds where yields are abysmally low, and going into high-yield bonds.
“Investors wouldn’t do that if they did not have confidence these companies would repay them.”