Bond hubris overwhelms Fed in riskiest credit-market sectors

Rising Yields

Yields on 10-year Treasury notes, a benchmark for everything from corporate bonds to mortgages, rose to 2.74% July 5, the highest since August 2011, from 1.93% May 21. That was the day before Bernanke said policy makers “could take a step down in our pace of purchases.”

Markets have since calmed. Treasury 10-year yields were little changed at 2.58% as of 8:35 a.m. in New York from Aug. 9. The price of the benchmark 2.5% note due August 2023, which was auctioned Aug. 7, was 99 10/32.

After initially pausing, high-yield credit markets have begun to rally again as investors seek alternatives to the zero rates engineered by the Fed.

Funds that purchase speculative-grade, or leveraged, loans in the U.S. attracted $2 billion last week, the second-biggest inflow on record, according to Charlotte, North Carolina-based Bank of America Corp. Companies will raise as much as $360 billion of the debt this year, Barclays Plc said Aug. 9, up from an earlier estimate of as much as $250 billion.

Lacking Safeguards

The market for so-called covenant-light loans that lack typical lender safeguards such as limits on debt has already soared to $155 billion this year, beating the record $96.6 billion in 2007, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.

Junk-bond sales rose 24% to $235.3 billion through Aug. 9 compared to the same period a year ago, according to data compiled by Bloomberg. Those securities and leveraged loans are rated below Baa3 by Moody’s Investors Service and less than BBB- at S&P.

Sales of payment-in-kind, or PIK, notes, which allow borrowers who can’t meet interest obligations to pay with additional debt, total more than $6.5 billion this year, on pace to top the $8.1 billion issued in 2012, Bloomberg data show.

Corporate bonds in the lowest rating tier of CCC made up 10.3% of the $22.4 billion in high yield sales in July, the most since 2011, according to JPMorgan Chase & Co.

While the recent activity is raising concern, it doesn’t match the frothiness of 2006 and 2007, when dealers packaged bonds backed by subprime mortgages into ever-riskier securities.

Better Shape

Global issuance of collateralized-debt obligations, or CDOs, backed by corporate loans and high-yield securities surged to a peak of $482 billion in 2006 from $5.7 billion in 1995, according to data compiled by trade magazine Asset-Backed Alert. CDOs are almost nonexistent now.

“The use of financing at that point was for” leveraged buyouts “and ever larger LBOs whose economics were doubtful and were proven to be disastrous,” Krishna Memani, the New York- based chief investment officer for OppenheimerFunds Inc.’s $79.1 billion fixed-income portfolio, said in an Aug. 6 telephone interview. “Issuers in the leveraged-loan market today are in much better financial shape than they were in 2007.”

Corporate default rates, at about 3%, are near historic lows, according to Moody’s, generating a sense of complacency among investors.

Memani said he likes “credit in all forms,” including investment-grade and high-yield company debt, emerging-market bonds and structured credit.

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