Investor Alert

Jan. 19, 2010, 10:15 a.m. EST

Yield Junkies Return to Bond Market

By Peter Lattman And Mike Spector

In the high-yield credit markets, it is time to party like it's 2006.

Companies left for dead a year ago are now finding that investors are clamoring for their high-yield debt. Private equity-backed businesses are paying their owners dividends out of new bond issues. In all, companies raised $11.7 billion last week in the high-yield bond market, the biggest in history, according to Thomson Reuters.

The previous record: $11.4 billion, set at the apex of the mid-decade credit boom in November 2006.

The latest demand seems all the more remarkable coming just over a year after the greatest financial panic in generations. The panic and a bleak economy helped pushed 11% of high-yield issuers into default in 2009, according to Standard & Poors.

Such sobering figures appear to be overlooked by investors. "It looks like risk is on the backburner again as investors are reaching for yield," said Adam Cohen , co-founder of Covenant Review, an independent credit research firm. "And issuers are all too happy to oblige in meeting the insatiable demand."

For most issuers, the new debt isn't going toward building new factories or funding big acquisitions. Instead, these new deals are improving the companies' balance sheets by repaying existing debt and pushing back maturities. These overleveraged companies hope they can get more time to improve operations and benefit from an economic recovery.

In March 2009, Hexion Specialty Chemicals Inc. said it planned to cut about 15% of its work force after posting a $921 million loss. That came after Standard & Poor's lowered its ratings on the Apollo Global Management LP-owned company, citing a risk that it would violate the covenant on its credit facilities.

On Thursday it sold $1 billion in high-yield bonds paying investors 9% interest. Investor demand was so large the company raised $300 million more than it had targeted.

Energy Future Holdings Corp., the Texas utility acquired by private-equity firms Kohlberg Kravis Roberts & Co. and TPG in 2007, sold $500 million of bonds earlier this month. The move followed a disappointing debt exchange in November in which the company sought to reduce its $44 billion debt load. The company has struggled amid the recession and a sharp drop in natural gas prices.

Some Wall Street deal makers say the current high-yield bonanza only delays the day of reckoning. With more than $1 trillion of corporate debt maturing prior to 2015, the recent new debt deals are "the ultimate Hail Mary passes," said Barry Ridings , the vice chairman of U.S. investment banking at Lazard Freres & Co.

While these high-yield bond deals can give companies breathing room, they also saddle them with increased interest payments. But companies are happy to use the proceeds to pay off less expensive senior bank loans. The bonds lack the restrictive covenants of loans, which often require minimum liquidity levels, restrictions on spending and other operational metrics borrowers must maintain.


Investors are eager for such new debt, in part because of economic policies emanating from Washington. With the Federal Reserve keeping interest rates near zero, yields on government debt have stayed low, forcing investors searching for decent returns to chase riskier paper like junk bonds.

"They're all yield junkies," said Mr. Ridings of Lazard. "Did everyone forget that 2008 happened? Talk about a short-term memory loss on the part of the buyer."

Indeed, at a time when small businesses and consumers are hard-pressed to get banks to turn on their lending spigots, some new bond issues are from companies for whom a capital raise a year ago would have been unthinkable. Last January, HeidelbergCement (FRA:DE:HEI) AG was struggling under a roughly $17 billion debt load and a worsening outlook for the construction industry. What is more, the company's owner, German billionaire Adolf Merckle, died in an apparent suicide as problems mounted in his business holdings.

Last Tuesday, HeidelbergCement successfully issued $2 billion in bonds, 40% more money than it expected to raise.

Some deals feature boom-era characteristics, such as private-equity firms issuing debt to take cash out of the companies they bought. Sorenson Communications last week placed a $735 million debt offering that will back a $180 million payout to its owners, Madison Dearborn Capital Partners and GTCR Golder Rauner LLC. This follow a number of these similar so-called dividend recapitalization deals in December.

The demand continues to drive gains in the trading markets in junk bonds and leveraged loans, which remain strong on the heels of record returns last year. After a 31.5% drop in 2008, high-yield and low-rated corporate bonds returned 57.5% in 2009, according to a Bank of America Merrill Lynch index. Leveraged loans returned 51.6% last year, according to an S&P/LSTA index. In the first two weeks of 2010, those indexes are up more than 2% and 1.9%, respectively.

The average gap between yields on high-yield bonds and U.S. Treasury bonds stands at about 6 percentage points, after starting the year at 6.4 percentage points. At the height of the credit bubble in early 2007, the spread had narrowed to under three percentage points. By December 2008, at the peak of the financial crisis, that so-called risk premium stood at about 22 percentage points, creating big returns for distressed investors.

For instance, Oaktree Capital Management, a firm that specializes in distressed debt, had a banner 2009. The Los Angeles-based firm managed $67.4 billion as of the end of September, up from $49 billion at the beginning of the year. Roughly 85% of Oaktree increase in assets has come from performance gains in its funds, many of which trade in high-yield bonds.

After such a rally, return expectations in the high-yield market for 2010 are more modest.

"The period of picking up dollars for 50 cents is behind us," said Dean Kehler , co-portfolio manager of New York-based Trian Credit Fund."

Oaktree Chairman Howard Marks said that, unlike the last several months, investing in the high-yield bond market now requires a discerning eye.

"A year ago everyone thought the world was ending, few people would invest at any price, and that brought the bargains of a lifetime," he said. "Today the market isn't overpriced or underpriced, so success lies in buying the right credits."


Write to Peter Lattman at peter.lattman@wsj.com and Mike Spector at mike.spector@wsj.com

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