Wall Street's New Flight to Risk

Even as Washington continues to rail against Wall Street for its role in the economic collapse, investors are once again turning to the kind of financial exotica that pumps up returns, and oh yes, risk. "While [risk is] not back to the eye-popping levels of 2007, investors have short-term memories," says Jason Mudrick, chief investment officer of Mudrick Capital Management in New York.

It's natural that money managers would be shedding their caution right now. The Federal Reserve has cut interest rates to the bone. Meanwhile, investors have rushed into debt markets. A record $155.3 billion poured into U.S. bond funds in 2009, according to research firm EPFR Global. All that cash is pushing down yields and raising frustration. Yields on junk bonds have fallen to 6.5 percentage points above Treasuries, from 22 points at the height of the crisis in December 2008.

Hence the renewed appetite for fancy securities with alluring interest rates. After a two-year hiatus, "payment-in-kind" bonds are making a comeback. The bonds, which allow cash-strapped borrowers to issue more debt to make their interest payments, helped fuel the private equity dealmaking frenzy when times were good. Hedge funds and other investors have picked up $1.85 billion of them since late last year. Johnson-Diversey Holdings sold $250 million of the bonds in November. The cleaning supply maker will be able to use cash or debt to pay its 10.5% interest for five years. Three weeks later, Wind Acquisition Holdings Finance, parent of Italy's third-largest mobile-phone company, raised $1.1 billion under similar terms. There was such demand that Wind Acquisition upped the size of its offering by 50%. "Six months ago I wouldn't have imagined being able to do this deal," says Karim-Michel Nasr, head of corporate development at Weather Investments, Wind's holding company. "It's an issuer's market."

The upside for companies is that they can conserve cash during lean times. But they also keep piling on debt. If a business ultimately goes bust, creditors will face even larger losses.

That is what's worrying investors who bought similar bonds back in the good old days, three years ago. In October 2007, buyout firms KKR and TPG paid $43 billion for TXU, the Dallas-based company now known as Energy Future Holdings. The electricity provider sold $4.25 billion of payment-in-kind bonds to help finance the deal, the largest private equity takeover in history. Energy Future has made some interest payments with debt and currently owes $4.75 billion on the securities. The bonds are trading at less than 77 cents on the dollar, according to Trace, the price reporting system of the Financial Industry Regulatory Authority. Lisa Singleton, an Energy Future spokeswoman, says the debt allows the company to maintain liquidity and increase financial flexibility.

Recent bond buyers say they're being cautious, paying close attention to the fundamentals. "Is it the early signs of froth and excess?" says William Cunningham, global head of credit strategies and fixed-income research at State Street's (STT) investment unit. "Not when you look at the numbers."

Then there are derivatives. Some banks are again pushing the simplest forms of synthetic collateralized debt obligations that bet on the severity of corporate defaults. Morgan Stanley (MS) and Bank of America (BAC) strategists recommended such investments to clients in December. "Most people we speak with are taking a very cautious approach," says Sivan Mahadevan, a Morgan Stanley derivatives strategist. "What you don't want is for investors to jump in indiscriminately." While the banks say such instruments help companies raise capital, former Federal Reserve Chairman Paul Volcker has blamed complex derivatives for taking the financial system to the "brink of disaster."

Leverage is also on the rise. Investors who buy mortgage securities backed by jumbo home loans now can borrow as much as $10 for every $1 in capital, amplifying returns. While a healthy economy needs some leverage, there's a dark side. As asset values plunged in 2007 and 2008, hedge funds that relied on borrowed money were forced to dump holdings or were wiped out altogether, such as London-based Peloton Partners. "I've got to be honest, leverage coming back this quickly is a little frightening," says Jim Shallcross, who oversees $12 billion in bonds at Declaration Management & Research in McLean, Va. "You can't assume everybody is going to do stuff rationally."

With Bryan Keogh, John Glover, and Tara Kalwarski

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