Firms Tripling Junk Returns Lure Most Since ’07: Credit Markets
Firms that use borrowed money to lend to the smallest and riskiest companies are attracting cash at the fastest pace since before the crisis, wooing buyers with returns that are triple those of the broader junk-debt market.
Investors from retirees to wealthy individuals plowed $4.1 billion into publicly traded business development corporations last year, the most since 2007, as the firms known as BDCs gained an average 16.4 percent. The entities are juicing returns by borrowing about 50 cents for every dollar raised from equity investors, up from 36 cents in 2011, as Keefe, Bruyette & Woods predicts average gains of as much as 13 percent this year.
BDC shareholders are wagering that an accelerating economy will bolster earnings for companies that are the most vulnerable to default, even as the Federal Reserve starts scaling back the unprecedented stimulus that suppressed borrowing costs. After shunning funds that used derivatives and leverage in the years after the 2008 credit crisis, buyers are returning to pad yields that reached record lows last year while seeking shelter from bonds that face losses as rates now rise.
“The market’s realizing there’s still this pocket of money that’s getting outsized returns,” said Troy Ward, a St. Louis-based strategist at KBW focused on BDCs. Because few investors are able to buy the infrequently traded loans directly, “there’s not that many buckets of capital that are chasing this asset class.”
Shares of TCP Capital Corp. (TCPC), the $605.7 million business development corporation based in Santa Monica, California, gained 25.2 percent last year including reinvested dividends, Bloomberg data show. Triangle Capital Corp. (TCAP), the $776.9 million middle-market lender based in Raleigh, North Carolina, was up 16.8 percent.
Ares Capital Corp., the biggest BDC, with a market value of $5.3 billion, returned 11.1 percent, while the $1.9 billion Apollo Investment Corp. (AINV) gained 11.5 percent.
The returns compared with 5 percent in the more established market for syndicated loans to speculative-grade companies, in which everyone from banks and insurance companies to mutual funds buy pieces of senior secured debt, according to the Standard & Poor’s Leveraged Loan 100 Index.
Juice to Toothbrushes
BDCs that have lent to companies from juice-maker Apple & Eve LLC to oral healthcare company Water Pik Inc. may return 9 percent to 13 percent this year, according to KBW estimates. JPMorgan Chase & Co. projects that syndicated loans will gain 4.5 percent. In the junk-bond market, where investors have a lower priority of being repaid in case of a company bankruptcy, the debt gained 7.4 percent in 2013, Bank of America Merrill Lynch index data show. JPMorgan strategists led by Peter Acciavatti predict they’ll return 5 percent this year.
Debt buyers funneled the second-biggest volume of cash ever into the lightly taxed BDCs last year, up from $3.87 billion in 2012, $1.3 billion in 2011 and $2 billion in 2010, KBW data show.
“It’s going to continue to attract a fair amount of investor interest,” said Theodore Koenig, chief executive officer of Chicago-based Monroe Capital Partners LP, which focuses on smaller corporate borrowers. “This has been a great asset class because credit has been relatively benign.”
Investors throughout the credit market are demonstrating greater willingness to take risks by investing with borrowed money after dollar-denominated corporate-bond yields fell to an unprecedented low of 3.35 percent on May 2, Bank of America Merrill Lynch index data show.
Credit Suisse Group AG, Bank of Nova Scotia and Citigroup Inc. are among firms extending between an estimated $60 billion and $75 billion of financing to money managers, enabling them to buy loans with less of their own capital. The net amount of trades on the three most-active derivatives indexes that allow investors to wager on the creditworthiness of investment-grade companies jumped to a weekly average of $117.3 billion in 2013, the highest in data going back to 2008.
The average ratio of debt to equity at BDCs was 50 percent in the three months ended Sept. 30, up from 47 percent in the prior quarter, KBW data show. That compares with 36 percent in the first three months of 2011 and 42 percent at the beginning of 2012, according to the data.
U.S. Congress is considering modifying existing regulations to allow more leverage at the firms than what’s currently permitted, potentially magnifying gains and losses in the future.
The legislation would permit BDCs to incur more than the current limit of one dollar of debt for every dollar of equity raised.
“One reason the structure has limited leverage is because you’re investing in illiquid assets,” KBW’s Ward said.
While investors have been piling into all junk-rated corporate debt to insulate themselves from rising Treasury yields, more of their cash has gone into the bigger and more widely traded market for syndicated loans.
That’s left a widening divide between borrowing costs in the two types of debt, with the smaller loans yielding 6.54 percent at year-end, 1.84 percentage points more than debt of larger companies, according to data from S&P’s Capital IQ Leveraged Commentary and Data. Middle-market companies, typically those with annual revenue of less than $500 million, obtained $13.4 billion of loans last year, while large corporations got $591.6 billion, S&P/LCD data show.
Investors are seeking out junk-rated, floating rate debt as 10-year Treasury yields rose to as high as 3.028 percent on Dec. 31, the most since July 2011. The Fed is reducing the pace of its monthly bond purchases to $75 billion this month from $85 billion as the U.S. unemployment rate dropped to 6.7 percent in December from as high as 10 percent in October 2009.
The world’s biggest economy expanded at a 4.1 percent annualized rate in the third quarter, the fastest since the final three months of 2011. The U.S. speculative-grade default rate dropped to 2.2 percent in the fourth quarter of 2013, from 2.7 percent in the prior quarter and 3.4 percent a year earlier, according to Moody’s Investors Service.
“BDCs have grown and become a more normal part of the market,” said Brett Palmer, president of the Small Business Investor Alliance. “They’re providing capital that a lot of others aren’t.”
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. fell for a second day. The Markit CDX North American Investment Grade Index, used to hedge against losses or to speculate on creditworthiness, decreased 1 basis point to a mid-price of 63.9 basis points as of 10:36 a.m. in New York, according to prices compiled by Bloomberg.
The index typically falls as investor confidence improves and rises as it deteriorates. Credit-default 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 of debt.
The U.S. two-year interest-rate swap spread, a measure of debt-market stress, rose 1 basis point to 13 basis points. The gauge typically widens when investors seek the perceived safety of government securities and narrows when they favor assets such as corporate debt.
Bonds of Petroleos Mexicanos are the most actively traded dollar-denominated corporate securities by dealers, accounting for 4.3 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Mexico’s state-owned oil company plans to raise at least $1.5 billion as soon as today selling dollar bonds due in five, 10 and 30 years, according to a person familiar with the offering.
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