Nov. 7 (Bloomberg) -- The worst part of the junk bond market is suddenly back in favor.

Companies raised about $4.4 billion in the past six weeks selling toggle bonds, securities that allow borrowers to pay interest in cash or with more debt, data compiled by Bloomberg show. Demand dried up in July and prices fell as much as 16 cents on the dollar as defaults on subprime mortgages contaminated global credit markets, according to data compiled by Bloomberg.

While Lehman Brothers Holdings Inc. estimates that mortgage losses will be as much as $250 billion in the next five years, the revival of toggles suggests that investors anticipate the economy will continue to grow and corporate defaults will stay near 25- year lows.

``When you have a lot of toggles, you know that the market's not too worried about risk,'' said Margaret Patel, who oversees $1.6 billion as a senior portfolio manager at Evergreen Investment Management Co. in Boston. They are ``a bull market security,'' she said.

The bonds accounted for about 18 percent of the $19.9 billion of new high-yield debt during October, up from an average of 8 percent in the first half of the year, when $8 billion were sold, Bloomberg data show.

Companies that issued the debt include Indianapolis-based auto-parts maker Allison Transmission, the Dallas-based power producer formerly known as TXU Corp. and human-resources manager Ceridian Corp. in Minneapolis.

Alltel, Avaya

Alltel Corp., the Little Rock, Arkansas, mobile-phone company that agreed in May to be acquired by New York-based Goldman Sachs Group Inc. and TPG Inc. for $24.7 billion, said last week that it will sell as much as $2.5 billion of toggles.

Basking Ridge, New Jersey-based Avaya Inc., the world's biggest maker of corporate phone network equipment, plans to sell $750 million of toggles and $700 million of notes that pay interest in cash to finance its leveraged buyout by Menlo Park, California-based Silver Lake Partners and Fort Worth, Texas-based TPG, according to a Nov. 1 statement.

Investors have started buying the securities because they yield as much as 1 percentage point more than bonds that don't have the option, Bloomberg data show. Ceridian offered $475 million of 12.25 percent toggles due in 2015 at a yield premium of 7.97 percentage points. It also sold $825 million in 11.25 percent senior notes due in 2015 at a spread of 6.97 percentage points.

Adequate Payment

``To us, it's about, are you getting paid adequately?'' said Paul Scanlon, managing director for high-yield at Boston-based Putnam Investments, which oversees about $65 billion in fixed- income. Putnam owns toggles sold by Dallas-based retailer Neiman Marcus Group Inc., according to Bloomberg data. Putnam has been buying more toggle bonds, Scanlon said, without specifying them.

The securities issued since September were rated at least six levels below investment grade by Moody's Investors Service and Standard & Poor's. Debt ranked below BBB- by S&P and Baa3 by Moody's is considered high-yield, high-risk, or junk.

The market for high-risk securities shut down when losses on securities tied to home loans made to people with poor credit threatened to slow the economy and cause companies to default. Banks such as Citigroup Inc. and JPMorgan Chase & Co. were stuck with more than $330 billion of debt to fund buyouts, including $11 billion of toggles, when demand evaporated.

Toggles Tumble

The bonds fell more than other high-yield company bonds. US Oncology Inc.'s notes due in 2012 tumbled 6.9 percent. Goodlettsville, Tennessee-based retailer Dollar General Corp.'s 11.875 percent bonds due in 2017 declined 16 percent in the two months after they were sold June 28, Bloomberg data show.

The Dollar General and other toggle securities rebounded as demand for high-yield debt recovered and the economy showed few signs of slowing. Junk bond sales in October were almost double the $11.2 billion sold in all of July, August and September.

Junk bonds returned 0.61 percent on average in October after gaining 2.44 percent in September, the most in four years. They advanced 1.12 percent in August following a loss of 3.14 percent in July, according to Merrill Lynch & Co.'s U.S. High Yield Master II Index.

``This market's one day at a time,'' said Andrew Feltus, who oversees $8.5 billion of high yield fixed-income assets as a fund manager at Pioneer Investment Management in Boston. ``It's going to stay volatile until the banks work out their problems, and that affects every other market out there.''

The Commerce Department in Washington said Oct. 31 that gross domestic product expanded at an annual rate of 3.9 percent in the third quarter, the most in more than a year. Two days later, the Labor Department said American employers added almost twice as many jobs in October as forecast by economists.

Neiman Marcus Debut

Toggles debuted in 2005 when Neiman Marcus sold $700 million of 9 percent, 10-year notes, Bloomberg data show. The retailer, owned by New York-based Warburg Pincus LLC and TPG, can make interest payments in debt instead of cash by tacking an additional 75 basis points, or 0.75 percentage point, to the coupon.

Nashville, Tennessee-based payment processor iPayment Inc. was the only other borrower to issue the securities until November 2006, when LBO financings by HCA Inc. and Freescale Semiconductor Inc. pushed sales to $3.65 billion for the month. HCA is also based in Nashville and Freescale is in Austin, Texas.

Feltus owns HCA toggles. ``Not only were you paid well,'' the hospital operator is unlikely to miss an interest payment, he said. Since September, Feltus's funds have purchased toggle bonds of Warsaw, Indiana-based orthopedic-implant maker Biomet Inc. on the secondary market and other new issues of the debt, he said.

Standard LBO Financing

LBO firms are willing to pay the higher coupon on toggles because they give more flexibility in times of financial trouble.

``Within a short period of time it became the standard LBO financing,'' said Martin Fridson, head of high-yield research firm FridsonVision LLC in New York.

The five biggest LBOs this year involving bond sales used or planned to use toggles, including the TXU and First Data Corp. deals, according to Bloomberg data. Kohlberg Kravis Roberts & Co. bought Greenwood Village, Colorado-based First Data, the largest processor of electronic payments, for $26 billion in September.

The yields on the bonds made them irresistible for investors at a time when defaults by U.S. companies rated below investment grade fell to 1.13 percent in September, the lowest in a quarter century, according to S&P.

``It didn't matter what the credit was, they all wanted toggle bonds,'' said Mark Hudoff, a money manager at Newport Beach, California-based Pacific Investment Management Co.

Three Instances

Pimco, a unit of Munich-based insurer Allianz SE, manages the world's biggest bond fund and owns more than $20 billion of high yield debt. Hudoff's High Yield Fund owns Freescale and Neiman Marcus toggles, according to filings with the U.S. Securities and Exchange Commission.

Borrowers have chosen to pay interest with additional debt three times since toggles were created, Bloomberg data show. IPayment and Bermuda-based mobile phone operator Digicel Group Ltd. issued additional securities instead of cash. US Oncology, the manager of cancer-treatment and research centers bought by Welsh, Carlson Anderson & Stowe, did the same on its first interest payment in September.

``A lot people don't want to be caught in the sunshine holding them,'' said Vicki Bryan, a senior high-yield debt analyst at Gimme Credit LLC in Friendswood, Texas. ``You don't know what's going to happen two years from now when the company gets in trouble. How do you know what's an accurate premium today for some event you can't foresee?''

Discounted Debt

The discounts being offered on some of the securities show investors are still wary.

Morgan Stanley, Citigroup and four other banks that financed KKR's $32 billion purchase of TXU, now known as Energy Future Holdings Corp., sold $2.5 billion of the debt by offering investors 76 basis points more in yield than on the company's bonds. The banks still hold $1.75 billion of the securities that haven't been sold, and as much as $13.5 billion in other notes and loans. Morgan Stanley and Citigroup are based in New York.

``It's going to be a case-by-case basis,'' said John Fenn, a high-yield strategist at Citigroup. ``I can assure you that no one's making new commitments for toggles.''

Allison Transmission, the automobile-parts supplier formerly owned by General Motors Corp., sold $550 million of toggles on Oct. 12. The 11.25 percent notes due in 2015 yielded 6.57 percentage points more than Treasuries of similar maturity. A day earlier, the company issued $550 million of 11 percent senior notes maturing the same year at a yield premium of 6.32 percentage points, Bloomberg data show.

``We haven't had a lot of companies needing to exercise the toggle because the economy's still in pretty good shape,'' said Fridson of FridsonVision. ``Once you get into an economy growing at negative 1 or 2 percent, I think it'll be a very different story.''

To contact the reporter on this story: Bryan Keogh in New York at bkeogh4@bloomberg.net; Sarah Rabil in New York at srabil@bloomberg.net

Last Updated: November 7, 2007 15:42 EST