Hard-to-Sell Junk Debt Lures Oaktree to JPMorgan: Credit Markets

Jan 23, 2014 9:37 am ET

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Jan. 23 (Bloomberg) -- 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.

‘Classic’ Cycle

“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.”

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.

‘Intoxicating Brew’

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.

Economic Boost

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.

“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.

More Homework

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.”

Credit Benchmarks

Elsewhere in credit markets, Anheuser-Busch InBev NV sold $5.25 billion of bonds to help fund its purchase of South Korea’s Oriental Brewery Co. Fitch Ratings is poised to increase the amount of investor protection in commercial-mortgage backed securities deals as lending standards deteriorate. Ecuador is considering its first foreign bond sale since a $3.2 billion default five years ago.

The cost to protect against losses on U.S. corporate bonds was little changed. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, held at 65.5 basis points, according to prices compiled by Bloomberg.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings increased 1.3 to 73.8 at 10:51 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia Index was little changed at 142.

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

AB InBev

AB InBev, the world’s biggest brewer, issued debt in six parts, including $1.4 billion of 3.7 percent, 10-year securities paying 85 basis points more than similar-maturity Treasuries, according to data compiled by Bloomberg. The maker of Budweiser and Corona is regaining control of Oriental Brewery in a $5.8 billion deal. It sold the business KKR & Co. in 2009 for $1.8 billion when it sought to cut debt following InBev NV’s $52 billion takeover of Anheuser-Busch Cos.

Fitch will require underwriters to boost the buffer that protects holders of commercial-mortgage bonds from losses if higher interest rates make it harder for landlords to pay off debt, the ratings company said in a report yesterday. Moody’s said it was taking a similar step in October.

Slipping Standards

Concern is mounting that lenders are lowering the bar as sales of securities linked to everything from strip malls to skyscrapers are forecast to surpass $100 billion this year after doubling to $80 billion in 2013, Bloomberg data show. One troubling trend is the increase in loans that delay principal payments, making it harder to refinance when the loan comes due, Fitch said.

In emerging markets, relative yields narrowed 2 basis points to 339 basis points, or 3.39 percentage points, according to JPMorgan’s EMBI Global index. The index has averaged 322.2 in the past 12 months.

The timing for any bond sale by Ecuador, which would be the South American country’s first overseas issuance since the default in 2008 and 2009, will “undoubtedly” be influenced by the Fed as it pares back stimulus that has suppressed interest rates, Economic Policy Minister Patricio Rivera told reporters in Quito yesterday.

“This is a good moment to analyze the eventual possibility that the republic sells” in the first half of the year, Rivera said. “There could be a good window of opportunity to sell this quarter. It’s much more probable that it’s in the first quarter. It depends a lot on how the market behaves.”

--With assistance from Sarika Gangar and Sarah Mulholland in New York and Nathan Gill in Quito. Editors: Shannon D. Harrington, Alan Goldstein