Sept. 5 (Bloomberg) -- Distressed bonds are increasing at the fastest rate in four years on growing concern that the era of record-low defaults is coming to an end.

The corporate bond market's favorite securities last year, so-called distressed debt, yield at least 10 percentage points more than Treasuries. Since June, the amount of distressed bonds has risen more than fivefold to $24.8 billion, according to an index Merrill Lynch & Co. began compiling in 1997.

Investor appetite for risk declined in the past two months as losses in securities linked to subprime mortgages caused sudden increases in the cost of credit and sparked concern that the worst U.S. housing market in 16 years will slow the economy. New York-based Moody's Investors Service expects the percentage of borrowers missing payments to double to 3.5 percent next year, as speculative-grade companies struggle to refinance about $22.7 billion of debt, up from $17 billion in 2007.

``Unless the market is being totally irrational, it's telling you default rates are going up,'' said Lawrence Post, chief executive officer of Beverly Hills, California-based Post Advisory Group LLC, which manages $8 billion in high-yield, or junk, debt. ``We're moving in that direction.''

Post was co-director of research and a senior trader at Drexel Burnham Lambert Inc., which pioneered the market for junk bonds, or debt rated below Baa3 by Moody's and BBB- by New York- based Standard & Poor's.

`Fewer' Alternatives

Debt of Minneapolis-based mortgage lender Residential Capital LLC and WCI Communities Inc., the homebuilder whose biggest shareholder is Carl Icahn, have lost as much as 19 cents on the dollar since June amid growing investor concern that they will fail to meet their payments.

Yield spreads on junk bonds ballooned to an average of 4.59 percentage points on Aug. 16, the highest in three years, from a record low of 2.41 percentage points on June 5, according to indexes kept by New York-based Merrill Lynch. More than 50 companies had to delay or rework debt offerings since June as demand dried up, according to data compiled by Bloomberg.

``The terms aren't going to be as advantageous as they once were and the availability of debt isn't going to be as great as it was,'' said Thomas Marshella, a managing director of leveraged finance at Moody's in New York. Those companies ``will have fewer market alternatives than they had the last several years.''

The amount of debt in the Merrill Lynch distressed bond index tripled in July to $13.8 billion, and about doubled again in August to $24.8 billion. In addition to Residential Capital and WCI, the debt of New York-based amusement park operator Six Flags Inc., and pizza chain Uno Restaurant Corp. of West Roxbury, Massachusetts, is distressed based on their yields.

Record Sales

More than 3.8 percent of high-risk bonds yield at least 10 percentage points more than Treasuries of similar maturity, up from 1.3 percent a month ago, Merrill Lynch data show.

Until June, companies had few difficulties refinancing debt because investors were confident an expanding economy and rising earnings would allow borrowers to meet their debt payments. That allowed the riskiest companies to lower their coupons and extend maturities.

Distressed bonds returned 43 percent in 2006, and 16 percent this year through June. Junk bond sales reached a record $101 billion in the first half of the year, a 55 percent increase over the same period of 2006, according to data compiled by Bloomberg.

Predicting Defaults

Moody's in January 2005 predicted the default rate would rise to 2.7 percent by the end of that year from 2.2 percent. Instead, it fell to 1.8 percent. Moody's then forecast it would rise to 3.3 percent by the end of 2006. It fell again, to 1.7 percent, the lowest year-end level in a decade.

``The last couple of years we always used to say `Gee, isn't it crazy, we're seeing top of market behavior and this can't be sustained,''' Marshella said. ``It did go on longer and we were wrong. You always thought there'd be an inflection point and, finally, an inflection point came,'' he said, referring the increase in financing costs caused by the contamination of asset- backed securities by subprime mortgages.

The appetite for high-risk securities continues even as credit market risks increase. Investors added $83 million to junk-bond funds in the week ended Aug. 29, the first increase in three months, New York-based JPMorgan Chase & Co. said, citing AMG Data Services, an Arcata, California-based firm that tracks mutual fund flows. Investors withdrew a net $2.1 billion from high-yield funds this year, according to JPMorgan.

Markets Stabilize

Deutsche Bank AG Chief Executive Officer Josef Ackermann said in a statement yesterday that financial markets are stabilizing after central banks pumped more than $200 billion into the world's money markets. The Frankfurt-based firm is the sixth-biggest underwriter of high-yield bonds in the U.S.

Harbert Management Corp. in New York last month decided against investing in distressed bonds of housing-related companies, said Edward Wu, a managing director at the firm.

``We continue to be bearish,'' said Wu, who helps manage about $15 billion, including distressed assets.

Residential Capital's $2.5 billion of 6.375 percent notes due in 2010 traded yesterday at 80 cents on the dollar to yield 16.5 percent, or about 12 percentage points more than similar- maturity Treasuries, according to Trace, the bond-price reporting system of the NASD. The debt is rated Ba1 by Moody's and has an investment-grade ranking of BBB- by S&P.

ResCap Injection

ResCap, as the company is known, is the biggest closely held mortgage lender. It's a unit of GMAC LLC, the Detroit-based automobile and home-finance company. GMAC last week said it will inject at least $775 million into the mortgage unit by shifting some health-care financing operations to another division within the company.

Gina Proia, a spokeswoman for ResCap and GMAC, didn't return phone calls seeking comment. General Motors Corp., the largest U.S. automaker, sold a 51 percent stake in GMAC last year to a group led by private equity firm Cerberus Capital Management LP of New York. Detroit-based GM has a 49 percent stake.

WCI's $200 million of 9.125 percent debt due in 2012 has tumbled about 14 cents this year to 82 cents on the dollar, according to Trace. The debt, rated Caa2 by Moody's and CCC- by S&P, yields 14.5 percent, or 10.3 percentage points more than Treasuries.

The Bonita Springs, Florida-based company's lenders agreed last month to amend the terms of the company's credit lines to help avoid a default.

Relaxing Terms

WCI's earnings before interest, taxes, depreciation and amortization can fall to as low as half its interest expense before the lenders would consider the loans in default, according to Chicago-based bond research firm Gimme Credit Publications Inc. Before, cash flow had to exceed interest expense by 1.75 times.

``We feel confident that we're going to be fine from a financial standpoint,'' WCI Chairman Donald Ackerman said in an Aug. 30 interview. The company plans to pay down as much as $700 million in debt this year, he said. ``We also have a lot of very, very good assets that can be turned into cash.''

WCI sells condominiums and houses targeted to affluent buyers, primarily in Florida. The average selling price for units in the company's high-rise towers was $1.1 million in the second quarter, down from $1.5 million a year earlier, WCI said Aug. 22.

The $300 million of 8.875 percent notes due in 2010 sold by Six Flags yield 10.7 percentage points more than Treasuries, while Uno's $142 million of 10 percent debt maturing in 2011 yields 14.6 percentage points above its benchmark. Six Flags is rated Caa1 at Moody's and B- by S&P. Uno's bonds have ratings of Caa2 and CCC.

Wendy Goldberg, spokeswoman for Six Flags, and Robert Vincent, chief financial officer of Uno, didn't return calls.

New Funds

Investors specializing in distressed debt are gearing up for more opportunities. They raised $23 billion this year through Aug. 17, breaking 2006's record of more than $16 billion, according to London-based Private Equity Intelligence Ltd.

WL Ross & Co., the New York-based investment company founded by billionaire Wilbur Ross, last month received a $200 million pledge from Oregon's public pension fund for a new $4 billion fund. New York-based Matlin Patterson Global Advisors is raising $4.5 billion for its third private-equity fund to invest in distressed debt, according to documents filed with the U.S. Securities and Exchange Commission in June.

``Now that things have changed, we can expect more defaults,'' said Jayme Wiggins, who is in charge of high-yield bond assets at Intrepid Capital Corp., the Jacksonville Beach, Florida-based money manager that oversees $450 million in assets.

To contact the reporter on this story: Caroline Salas in New York at csalas1@bloomberg.net

Last Updated: September 5, 2007 04:02 EDT