No Loan Left Behind in Legg Mason’s Debt Pursuit: Credit Markets

Legg Mason, the Baltimore-based money manager overseeing $636 billion, is starting a fund to invest in loans to so-called middle-market companies.  Photographer: Andrew Harrer/Bloomberg
Legg Mason, the Baltimore-based money manager overseeing $636 billion, is starting a fund to invest in loans to so-called middle-market companies. Photographer: Andrew Harrer/Bloomberg

Companies left behind in the biggest U.S. bond-market rally ever are catching up as investors from Legg Mason Inc. to New York State’s biggest pension fund seek an alternative to junk-bond yields at record lows.

The gap in borrowing costs between the smallest companies with limited access to capital markets and bigger firms that can offer bonds shrank to the least this year, according to Standard & Poor’s Capital IQ Leveraged Commentary & Data. Relative yields on loans to borrowers with earnings of $50 million or less fell to 0.74 percentage point more than those of the biggest companies on Aug. 16, from 1.27 percentage points in January.

Legg Mason, the Baltimore-based money manager overseeing $636 billion, is starting a fund to invest in loans to so-called middle-market companies, joining Tennenbaum Capital Partners LLC and the New York State Common Retirement Fund. The funds are proliferating as the Federal Reserve says it expects to hold interest rates near zero through at least late 2014.

“The middle-market right now is extraordinarily competitive,” said E.A. Kratzman, president of Katonah Debt Advisors LLC in New York. The most-active investors “are willing to take down very, very large swaths” of loans to the smallest issuers, he said.

Boosting Returns

Those corporate borrowers, which typically haven’t had access to the $4.8 trillion U.S. market for company bonds, are attracting investors even as the U.S. unemployment rate held above 8 percent in July for a 42nd month.

The Fed’s latest quarterly survey of senior loan officers at banks released Aug. 6 said while lenders loosened standards for loans to large and medium-sized firms, those for small business were little changed for the fourth consecutive period.

“The market has a lot of growth in front of it,” said Chris Flynn, a managing director at THL Credit Advisors LLC, the $2.8 billion debt investment arm of private-equity firm Thomas H. Lee Partners LP. “It’s much more of an originate buy-and-hold market given the lack of liquidity than what you see in the broader debt market.”

Elsewhere in credit markets, JPMorgan Chase & Co. is planning to issue $500 million of perpetual preferred shares. The Federal Reserve Bank of New York is offering the final blocks of holdings in its Maiden Lane III LLC portfolio. Benchmark gauges of corporate credit risk in North America and Europe fell to the lowest in 15 weeks.

JPMorgan Preferreds

JPMorgan may issue $25 perpetual preferred shares as soon as today at a yield of 5.5 percent to 5.625 percent, according to a person familiar with the transaction, who asked not to be identified because the terms aren’t set. The securities are callable after five years.

Banks are selling preferred shares in part to get ready for changes in capital regulations linked to the Basel III international banking requirements, Marc Pinto, head of corporate bond strategy at Susquehanna International Group LLP, said in a telephone interview. There has been $7.5 billion in $25 per share preferred issuance over the past six weeks, according to Pinto.

Bonds of New York-based JPMorgan were the most actively traded dollar-denominated corporate securities by dealers today, with 34 trades of $1 million or more as of 11:55 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

Maiden Lane

The securities circulated by the New York Fed today represent the last of the debt in Maiden Lane III, Jack Gutt, a spokesman for the district bank, said in a telephone interview. The Fed created Maiden Lane III to purchase $62.1 billion in collateralized-debt obligations and keep American International Group Inc. from collapsing.

The Markit CDX North America Investment-Grade index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, declined 0.4 basis point to a mid-price of 99.2 basis points as of 12:03 p.m. in New York, according to prices compiled by Bloomberg. That’s the lowest since May 4.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings declined 3.5 basis points to 141, the lowest since May 3.

The indexes typically fall as investor confidence improves and rise as it deteriorates. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million.

Commercial Loans

Commercial and industrial loans outstanding at banks in the U.S. rose to 1.47 trillion as of Aug. 8, according to the Fed. While that’s up from about $1.2 trillion in October 2010, it’s still below the peak of $1.61 trillion in October 2008.

With its new fund targeting the smallest corporate borrowers, Legg Mason is seeking to profit in a business Wall Street largely abandoned after the credit crisis in 2008. Its new closed-end fund aims to give investors their money back after eight years, according to an Aug. 10 prospectus filed with the U.S. Securities and Exchange Commission.

It’s seeking to boost returns by investing in debt that isn’t frequently traded such as the corporate-bond market, where average yields on U.S. speculative-grade securities have dropped to 7.4 percent, 0.2 percentage point from the record low reached in May 2011 based on Bank of America Merrill Lynch index data.

Junk Returns

Those securities have returned 108 percent since 2008, the biggest four-year rally since Michael Milken helped create a market for the securities in the 1980s.

Middle-market companies “typically have shorter operating histories, narrower product lines and smaller market shares than larger businesses,” with less predictable income and ability to raise debt, Legg Mason said in the prospectus for the fund, which will be managed by its Western Asset Management Co. unit.

Smaller companies “have been forced to find alternative funding sources and are willing to pay a high interest rate and include covenant features which benefit investors,” according to the filing. Banks “continue to restrict their lending activity, particularly to small and mid-sized corporations.”

Investors generally demand higher yield premiums for debt that isn’t traded frequently because it’s more difficult to sell if the creditworthiness of the borrower deteriorates or if the investor needs to raise cash quickly.

Monroe, Tennenbaum

Tennenbaum Capital, a $4.5 billion credit investor in Santa Monica, California, is also raising money to invest in middle-market debt, according to the San Bernardino County Employees’ Retirement Association, which was considering investing in a middle-market fund.

The New York State Common Retirement Fund, with about $150.3 billion of assets, committed money for the first time this year to funds from Brightwood Capital Advisors LLC and Monroe Capital Corp., according to a February monthly transaction report.

The 0.74 percentage-point gap between relative yields on loans to the smallest corporate borrowers and the biggest is the tightest since 2010, when the difference was 0.42 percentage points, according to S&P/LCD data, which before this year only tracked the data annually.

In 2008, the smallest borrowers were paying 0.27 percentage points more than bigger companies, which S&P/LCD defines as having more than $50 million of annual earnings before interest, taxes, depreciation and amortization.

Cash Flush

Middle-market loan yields averaged 7.46 percent as of Aug. 16, compared with 6.67 percent on loans to larger companies.

Middle-market loans are attracting investors who funneled an unprecedented $44.9 billion in high-yield bond funds globally through Aug. 8, up from $14.3 billion in the same period last year, according to Cambridge, Massachusetts-based EPFR Global.

Investors are seeking to boost returns as yields on U.S. Treasuries hover near an unprecedented 1.38 percent reached on July 25. Junk bonds have gained 9.6 percent this year, including reinvested interest, Bank of America Merrill Lynch index data show, compared with 14.4 percent returns on the S&P 500 index when including reinvested dividends.

“We’re in a multi-year rotation into credit investing in general among investors,” said Michael Herzig, a managing director at THL Credit, based in Boston. “The middle market is a little tougher to access than” publicly trade high-yield debt, he said.

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