Why Junk Bonds Are Getting Junked

Leveraged loans offer better terms, but their floating rates could spell trouble

Time was when the junk-bond market was a vital source of cash for a capital-intensive paper company wanting to borrow billions. Not now. On Jan. 27, Georgia-Pacific Corp. raised $11 billion with no help whatsoever from the junk market. It got its money from so-called leveraged loans, which are speculative-grade loans secured by company assets.

Companies are flocking to leveraged loans because they're offering the cheapest and most plentiful debt capital in at least eight years -- far better than what's available via junk bonds. The terms are so attractive that leveraged loans are pushing aside junk as a key debt instrument for leveraged buyouts. In the past year LBO firms used leveraged loans for all or part of the financing involving retailers Neiman Marcus and Toys 'R' Us, direct marketer Affinion Group, and satellite Internet provider Hughes Network.

The movement toward leveraged loans goes hand in hand with the broader shift in credit markets to jack up leverage and shift risk through new instruments such as credit default swaps and collateralized debt obligations. The trouble is, leveraged loans, unlike regular old junk bonds, have floating interest rates. Typically, the rates are just a few percentage points above the London Interbank Offered Rate, or LIBOR, which is the dirt-cheap rate that banks charge one another for short-term money. The terms on those loans might seem attractive when they're taken. But if interest rates rise, the result could be disastrous for companies that have taken on too much debt.

And more companies are facing the temptation to leverage up as investors flood the market with capital. Leveraged loans were once traded quietly among bank syndicators and a few institutional investors. Now these loans are attracting gobs of money from hedge funds, pension funds, mutual funds, and others. Investors funded a record $295 billion in leveraged loans in 2005, three times as much as in junk bonds, according to Standard & Poor's (MHP ) LCD unit, which gathers market data.

The attraction for investors: floating rates, which they prefer at this point in the economic cycle because they think that long-term interest rates will climb, eroding the value of junk bonds. (When interest rates go up, bond prices go down.) What's more, in the event of a bankruptcy, loan holders have a stronger claim on corporate assets than bondholders have.


But the easy money has allowed corporate borrowers to ratchet up their debt burdens to the highest level since 1999. And as the debt burdens climb, companies run greater risks of being unable to pay their interest and defaulting on their debt. For now, default rates remain low at 1.8% of issuers, less than half the historical mean, according to Moody's Investors Service (MCO ). But Moody's expects default rates to rise to 3.3% in 2006.

The most worrisome part of the leveraged loans explosion is the mushrooming market for so-called second-lien loans. These loans work like second-home mortgages for consumers, allowing companies to borrow more against their assets -- but at interest rates about four percentage points higher than first-lien loans. Investors, drawn to the higher yields, are pouring in. Last year they funded $16.3 billion of second-lien loans, 25 times the amount in 2002. These loans, notes Steven C. Miller, managing director at LCD, used to be taken chiefly for "rescue money" to shore up troubled companies. Now companies are taking on these pricier loans for other, less pressing objectives.

Ultimately, second-lien loans might prove to be too successful for the leveraged loan market's own good. As the loans fund more corporate debt, and as their higher floating rates drive up companies' interest expenses, more borrowers are setting themselves up for default. Martin Fridson, the chief executive officer of FridsonVision LLC, a New York-based debt market research service, predicts that this bull market in credit will end as the others have, with massive defaults and investors fleeing. But that probably won't happen before 2008. Doomed loans take a few years to go bad, Fridson explains. In the meantime, the sale on money continues.

By David Henry

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