Enigma of Junk Explained in Pension Fund’s Return Hurdle

To understand why investors are willingly accepting the lowest yields ever on the riskiest corporate securities, look to Japan.

As central banks around the world keep interest rates near zero and investors struggle to find ways to boost returns, managers of Japan’s $1.25 trillion Government Pension Investment Fund said in minutes of a March meeting released in May that they’re considering loosening their practice of only buying investment-grade debt and venturing into junk bonds.

Emboldened by default rates that are half of historical averages and an accelerating economy, investors across the globe have have poured $23.3 billion this year into high-yield bond funds, EPFR data show. They’re shrugging off warnings that the securities are a bubble waiting to burst, taking comfort in promises from Federal Reserve, European Central Bank and Bank of Japan policy makers that they’ll keep pumping cash into the financial system.

“We’re in a benign default environment,” said Eric Takaha, the director of corporate and high-yield group at Franklin Templeton Investments (BEN), which manages $350 billion in fixed income.

“If you had the credit outlook moving in the wrong direction you wouldn’t see the same level of enthusiasm,” he said in a June 3 telephone interview from his San Mateo, California, office.

Default Rate

Takaha said the relatively low number of companies whose debt is trading at distressed levels bodes well. Moody’s Investors Service predicts its global speculative-grade default rate will fall to 2.3 percent by year-end from 2.4 percent in April. That compares with a historical average of 4.7 percent.

Denmark’s PFA Pension A/S, which manages more than 400 billion kroner ($73 billion) in assets, cut its holdings of investment-grade bonds last year in favor of emerging markets and high-yield securities, Henrik Henriksen, chief investment strategist, said in a telephone interview.

“We can’t see any hike in bankruptcies and losses in the next six to 12 months thanks to the relaxed monetary policy and the recovery both in the U.S. and Europe,” Henriksen said, adding that China and Japan are also trying to boost growth. “So, we simply can’t see any recession or reversal of the cycle on the horizon.”

Accelerating Growth

The world economy will probably expand at a 2.74 percent rate this year and a 3.11 percent rate in 2015, accelerating from 2.09 percent last year, according to analysts surveyed by Bloomberg.

ECB President Mario Draghi today unveiled an unprecedented round of stimulus measures to support an economy threatened by deflation. Draghi said officials will start work on purchases of asset-backed securities after the ECB became the first major central bank to take one of its main interest rates below zero by cutting its deposit rate to minus 0.1 percent.

Not all fund managers are as sanguine about the prospects for debt rated below investment grade. Los Angeles-based TCW Group Inc. has been limiting high-yield corporate bonds and shunning emerging-market debt, said Tad Rivelle, who oversees about $95 billion as chief investment officer for fixed-income.

“The time for the risk-on trade was four or five years ago,” Rivelle said in a May 29 interview at Bloomberg News headquarters in New York.

Hedging Credit

Yields on junk bonds -- those rated below Baa3 by Moody’s and lower than BBB- by Standard & Poor’s -- fell to a record-low 5.77 percent on June 2, down from an all-time high of 23.2 percent in December 2008, according to Bank of America Merrill Lynch index data. The debt has returned more than 155 percent since the end of 2008.

Morgan Stanley (MS) strategists led by Adam Richmond wrote in a May 23 report that “hedging credit risk is both cheap and a sensible strategy in this environment.”

Investors lured by extra yield should be more cautious, according to Fred Senft, director of fixed-income and equity research at Cleveland-based KeyCorp’s private banking unit.

“It’s a little bit of a ‘Me, too’ market; they feel they need to keep up with some of the others and they’re going down that path,” Senft said in a telephone interview. “We hope the perfect credit environment doesn’t turn into the perfect storm.”

Junk Sales

Central-bank balance sheets have been pouring trillions of dollars into the financial system since the credit crisis, putting more money in the hands of investors who keep climbing down the credit ladder in search of yield. The combined balance sheets of the Fed, ECB, BOJ and Bank of England had more than doubled to $10.4 trillion as of May 23 from $4.2 trillion on Sept. 12, 2008, according to Bianco Research LLC.

Global junk-bond issuance topped $265 billion during the first five months of the year, a record for the period, according to data compiled by Bloomberg. The extra yield, or spread, investors demand to own the debt instead of government securities narrowed to 3.83 percentage points yesterday, the lowest since 2007, according to Bank of America Merill Lynch index data.

Japan’s GPIF said in the meeting minutes released last month that they are considering putting its money in junk bonds. The 128.6 trillion yen fund needs the riskier debt because maintaining a low-risk, low-return policy may lead to a “pension crash” as the nation’s population ages the fastest in the world, Health Minister Norihisa Tamura said last month.

Caa Rated

“Investment opportunities in Japan are becoming very limited, and it makes sense to take a chance with overseas assets if it’s long-term investment of 20 to 30 years,” said Manabu Tamaru, a fund manager who helps oversee about 500 billion yen of fixed-income assets at Baring Asset Management (Japan) Ltd. “The scope for Japanese debt yields to fall further is limited, whereas foreign bonds are still attractive.”

In the U.S., Third Avenue Management LLC’s Focused Credit Fund, is the best performer among high-yield funds this year with 10.2 percent gains and has been increasing its holdings of debt rated Caa and Ca by Moody’s, according to Morningstar Inc. (MORN) and Bloomberg data.

Debt rated Caa comprised about 49.5 percent of its $3.3 billion in assets as of June 3, up from 47.3 percent at the start of the year, according to data compiled by Bloomberg. The fund also increased its holdings of securities rated Ca to 10.2 percent from 3.7 percent at the end of December.

Carissa Felger, a representative for Third Avenue who works at Sard Verbinnen & Co., declined to comment.

“The guy who has had the highest allocation is obviously winning because he’s had good returns,” William Larkin, a money manager who oversees $520 million in assets at Cabot Money Management in Salem, Massachusetts, said in a telephone interview. While the current spreads make him “nervous,” he said, “you’ve got to get a fair return, you can’t be buying Treasuries at these levels.”

To contact the reporter on this story: Caroline Chen in New York at cchen509@bloomberg.net

To contact the editors responsible for this story: Shannon D. Harrington at sharrington6@bloomberg.net Caroline Salas Gage, Faris Khan

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