Japan's Yield-Starved Investors Are Snapping Up Risky US Loans

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Japanese investors are plowing back into the same types of risky U.S. corporate-loan investments that caused them losses during the 2008 credit crisis.

They’re pouring cash into loans to finance Burger King operator Restaurant Brands International Inc., hotel manager Hilton Worldwide Finance LLC and Caesars Entertainment Resort Properties LLC. They’re snapping up pools of the debt that have been sliced into pieces of varying risk and return, and converted into yen-denominated securities.

The logic is simple: These buyers are desperate for a way to juice returns with local sovereign bonds yielding almost nothing, and speculative-grade loans offer more than five extra percentage points of compensation. Some analysts and investors say the desire for yield is blinding Japanese investors to the risks as U.S. regulators warn that underwriting standards have slipped too far.

“In the U.S., people have become a little skeptical” of the asset class, said Yusuke Ueda, a credit analyst at Bank of America Merrill Lynch in Tokyo. Japanese investors “are just buying anyway,” he said.

Buyers include regional banks, credit unions, and asset-management arms of the nation’s two largest banking groups, Mitsubishi UFJ Financial Group Inc. and Sumitomo Mitsui Financial Group Inc. Funds of both firms ranked a junk-rated $4.3 billion loan to PetSmart Inc., the Phoenix, Arizona-based pet-supplies company, among their top-ten holdings as of March.

Default Outlook

Right now, default rates in the U.S. are historically low, and Moody’s Investors Service predicts they’ll remain subdued this year, at about 2.7 percent by December. The ratings company does see the potential for problems further out.

“We’re concerned that banks that originated highly leveraged transactions over the past several years may be unwilling to refinance those transactions in the future,” Min Xu, a Moody’s analyst, wrote in an April 15 report. “These issuers are likely to become vulnerable to default risk.”

The surge in Japan comes as U.S. demand shows signs of fizzling. While speculative-grade loans were more popular than ever with U.S. mutual fund investors in 2013, they’ve since lost their luster. About $6.9 billion has been withdrawn from those funds this year, according to data compiled by Wells Fargo & Co. That’s on top of last year’s record $23.9 billion outflows recorded by data provider Lipper.

Floating-Rate Interest

By contrast, Japanese individual investors bought a net 222.6 billion yen ($1.9 billion) of the loans sold domestically in funds last year, up from 87.2 billion yen a year earlier, Morningstar Inc. data show.

Part of the allure of leveraged loans is that they offer floating-rate interest payments, which is appealing as the Federal Reserve prepares to raise borrowing costs. They also rank ahead of bonds issued by the same companies in a bankruptcy.

Banks and money managers are trying to make it easy for Japanese investors to become more active. Blackstone Group LP and Mitsubishi UFJ Morgan Stanley Securities Co. filled a Tokyo ballroom in February with locals for a seminar on U.S. and European bank loans.

Neuberger Berman Group, the money manager once part of Lehman Brothers Holdings Inc., is running out of space at its Tokyo premises as business expand. Guggenheim Partners LLC opened its first office in the country in July, and the investment firm obtained advisory and agency licenses in February.

Bond Conversion

It’s even harder for Japanese investors to refuse the debt when it’s packaged with a currency hedge, and others are willing to manage the loans for them. Guggenheim is among asset managers of the underlying loans that converted debt issued by collateralized loan obligations -- which repackage a pool of leverage loans -- into AAA rated yen bonds in deals arranged by Mitsubishi UFJ.

The first such deal rated by Moody’s was created in March 2014, and at least eight more have been issued since, according to the credit rater.

Japanese investors are being lured into the loan market at the same time regulators, including the Fed, warn investor protections have weakened too much. The push from bank supervisors is an effort to prevent a repeat of what happened when credit markets seized up seven years ago.

Prices on U.S. loans plunged as low as 59.2 cents on the dollar in 2008, fueling losses at banks including Tokyo-based agricultural lender Norinchukin Bank and Mizuho Financial Group Inc., both of which made wrong-way bets on U.S. subprime and collateralized loan obligations.

Mizuho, Norinchukin

Mizuho ramped up its structured-finance business for packaging U.S. subprime debt at the end of 2006 just before the market crashed, while Norinchukin sank trillions of yen into CLOs, mortgages and asset-backed securities overseas that resulted in losses. The two alone had 1.16 trillion yen in combined deficits in the year ended March 31, 2009.

Leveraged-loan prices have since rebounded to an average 96.7 cents and reached as high as 99.1 cents last July. Now, many Japanese are ready to buy once again, according to Jeremy Ghose, a former executive at Mizuho who currently heads the debt unit of 3i Group Plc, a London-based private equity firm. He said he hasn’t seen such demand in the 25 years he’s been coming to the country.

“The yields for Japanese government bonds are pressuring firms, pension funds, insurance companies and financial institutions to look outside of Japan,” Ghose said in an interview last month.

Record Purchases

Money has been pouring into overseas assets as the Bank of Japan pushes ahead with its unprecedented bond buying program to ignite growth. Japan overtook China as the top foreign holder of U.S. government debt in February for the first time since the global financial crisis.

The BOJ kept a plan to expand the monetary base at an 80 trillion yen annual pace Thursday, even as it cuts its growth and price estimates for the year through March and said it now sees price gains reaching its goal in the first half of the following fiscal year.

At the same time, concern is growing that underwriting standards have deteriorated too much as the global hunt for yield intensifies. The lax lending practices prevalent in the run-up to the crisis have made a comeback, according to David Hunt, the chief executive officer of Prudential Investment Management Inc., which manages $934 billion.

“I’d say in the last 18 months we’ve started to see some of that return, for the very first time,” Hunt said in an interview in Tokyo earlier this month. “We all as an industry need to be careful we don’t fall back into some of the ways that got us into trouble in the first place.”

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