Dec. 29 (Bloomberg) -- Toys ``R'' Us Inc. bondholders are gaining confidence in Chief Executive Officer Gerald Storch.

The retailer's $400 million of 7.375 percent notes due in 2018 have gained 10.26 cents on the dollar to 81.25 cents since July 20, their highest price in 16 months, according to Trace, the bond-price reporting system of the NASD.

Storch, a former Target Corp. executive, was hired by Bain Capital LLC and Kohlberg, Kravis Roberts & Co. in February after three quarters of losses. He's cut 3,000 jobs, closed 87 stores and introduced exclusive products to compete with larger Wal-Mart Stores Inc. That helped Toys ``R'' Us, the second-biggest U.S toy retailer, post a profit of $29 million in the third quarter ended Oct. 28.

``There has been more discipline, and you've seen an improvement from an ownership perspective,'' Charlie O'Shea, an analyst at Moody's Investors Service in New York, said in an interview. Storch's ``background at Target is certainly a plus. He brings a different perspective from a retailer that's very successful across the board.''

The bonds due in 2018 have returned 18 percent including reinvested interest since July 20, according to data compiled by Bloomberg and Trace. They dropped to a low of 69.50 cents in July on concern Wayne, New Jersey-based Toys ``R'' Us would default on its $6.72 billion in debt.

Bonds rated below investment grade gained 7.8 percent in the same period, according to index data compiled by Merrill Lynch & Co. Toys ``R'' Us bonds are rated CCC by Standard & Poor's and Caa1 by Moody's. Debt ranked less than BBB- at S&P and Baa3 by Moody's is considered non-investment grade, or junk.

`Season to Buy'

The retailer's debt ``was cheap, and it's the season to buy their products,'' said Scott MacDonald, head of research at hedge fund Aladdin Capital Management in Stamford, Connecticut, which manages $14 billion in assets.

Sales at U.S. Toys ``R'' Us stores open at least 56 weeks rose 0.4 percent in the third quarter after a decline of 8.9 percent a year earlier. International toy store revenue climbed 5.3 percent and Babies ``R'' Us sales jumped 6.2 percent, the company said on Dec. 12. Sales were helped by toys from the ``Cars'' movie and the back-to-school season.

Toys ``R'' Us debt gained during the Christmas season as parents snapped up the company's exclusive pink $49.99 Nitro Notebook computers, Nintendo Co.'s Wii video game consoles, Mattel Inc.'s T.M.X. Elmo and the tap-dancing penguin Mumble from Warner Bros.'s animated film ``Happy Feet.''

Never Before

``We're seeing volumes like we've never seen before,'' Storch, 50, said in a Dec. 19 interview from his office. Storch left top Target, where he was vice chairman, in October 2005.

Besides Storch, Toys ``R'' Us this year named F. Clay Creasey as the new chief financial officer and Best Buy Co. executive Ronald Boire to head the U.S. toy division.

The bonds rose from 77.12 on Nov. 22, just before Thanksgiving, the start of the holiday retail period. Toys ``R'' Us hasn't reported Christmas sales.

Credit-default swap contracts based on $10 million of Toys ``R'' Us bonds have fallen 37 percent to $495,000 from $785,000 on June 27, near the lowest level since October 2005, according to data compiled by Credit Market Analysis. The swaps imply a 33 percent chance Toys ``R'' Us will default within five years, down from 48 percent in June, according to a JPMorgan Chase & Co. valuation model used by Bloomberg.

Credit-default swaps, financial instruments based on bonds and loans, were conceived about a decade ago to protect bondholders against default. They pay the buyer face value in exchange for the underlying securities should the company fail to adhere to its debt agreements. A decrease indicates an improving perception of credit quality; an increase suggests the opposite.

Dividend Risk

Toys ``R'' Us debt soared from $1.63 billion in April 2005 after it was acquired in July 2005 for $6.6 billion by leveraged buyout firms Bain, KKR and real estate developer Vornado Realty Trust.

KDP Investment Advisors analyst Barbara Cappaert this month maintained her ``sell'' recommendation on the bonds because there is a ``likelihood'' during the next two years that the company's owners will pay themselves dividends from asset sales or operating profits rather than reduce the company's debt. She didn't return a call for comment.

More than 80 companies controlled by LBO firms borrowed to pay themselves dividends, according to data compiled by Bloomberg and S&P.

``The elephant in the room is the debt level, which is kind of difficult to ignore,'' said O'Shea of Moody's, which has a ``negative'' outlook on its rating.

Toys ``R'' Us has enough cash and available credit to stave off default ``for the foreseeable future,'' said Evan Mann, an analyst with New York-based independent bond research firm Gimme Credit Publications Inc. ``Unless there is some big surprise, the credit is going to be OK for a while.''

To contact the reporter for this story: Shannon D. Harrington in New York at sharrington6@bloomberg.net; Caroline Salas in New York at csalas1@bloomberg.net

Last Updated: December 29, 2006 11:43 EST