Pimco to DoubleLine Leveraging as Yields Retreat: Credit MarketsLisa Abramowicz
Junk-bond yields have fallen so far that the world’s biggest debt investors are turning to borrowed money to juice returns, a practice that magnified losses during the worst financial crisis since the Great Depression.
Bill Gross’s Pacific Investment Management Co. said it plans to sell as much as $3.3 billion of shares for its Pimco Dynamic Credit Income Fund, poised to become the largest taxable income closed-end fund. DoubleLine Capital LP is starting its Income Solutions Fund that may invest an unlimited amount of its assets in speculative-grade debt, according to a Jan. 15 filing.
Leverage is staging a comeback for investors that oversee more than $2 trillion as speculative-grade yields reach record lows daily with the Federal Reserve holding benchmark interest rates at about zero percent for a fifth year. Blackstone Group LP’s debt investment arm obtained a $425 million line of credit last month for its Strategic Credit Fund, which started trading in September as part of the biggest wave of initial public offerings for closed-end funds since 2007.
“Everybody’s looking for income,” said Sangeeta Marfatia, a strategist at UBS Securities LLC in New York. Closed-end funds “can go out and borrow really cheap and yet they’re able to invest at much higher rates.”
Pimco’s new fund, which started trading today, may borrow as much as 42 percent of net assets, according to a Jan. 25 filing from the Newport Beach, California-based manager of the world’s largest bond fund. Initial public offerings of closed-end funds, which trade on exchanges and seek to boost gains using leverage, reached $11.6 billion last year, almost double the $5.9 billion in 2011, according to Thomas J. Herzfeld Advisors Inc. More than half of the new funds focused on credit investments.
Investors clamoring for greater returns deposited an unprecedented $72.4 billion last year into funds that own speculative-grade debt, rated below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s, according to data from EPFR Global in Cambridge, Massachusetts.
While junk yields in the U.S. have plunged to 6.41 percent, bond buyers are still pouring cash into the notes as they speculate that the U.S. economy has “more upside than downside risk” in a low-rate environment, JPMorgan Chase & Co. credit strategists led by Peter Acciavatti in New York wrote in a Jan. 25 note.
Borrowed money invested in mortgage bonds accelerated losses during the credit crisis by forcing sales by holders as margin calls arose, boosting supply and sending prices lower.
“I don’t think you get a repeat of 2008 because the leverage in the system isn’t anything close,” Jeffrey Gundlach, chief executive officer of Los Angeles-based DoubleLine, with about $53 billion in assets, said last month in a Bloomberg Television interview. “You would need the leverage in the system to go up more, and maybe it will.”
Elsewhere in credit markets, the cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark used to hedge against losses or to speculate on creditworthiness, increased 0.9 basis point to a mid-price of 86.7 basis points as of 12:20 p.m. in New York, according to prices compiled by Bloomberg.
The measure typically rises as investor confidence deteriorates and falls as it improves. The contracts 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, decreased 0.61 basis point to 16.01 basis points as of 12:21 p.m. in New York. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.
Bonds of Morgan Stanley are the most active dollar-denominated corporate securities today, accounting for 3.42 percent of the volume of dealer trades of $1 million or more as of 12:17 p.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.
Pimco’s Dynamic Credit Income Fund intends to borrow money “as soon as reasonably practicable following the completion of the initial public offering,” according to the Jan. 25 prospectus. It may invest in a range of fixed-income securities, from corporate debt and mortgage-backed securities to government and municipal bonds.
If the new fund succeeds at raising the full $3.3 billion, it will become the biggest taxable-income closed-end fund, according to data from Morningstar Inc. It will be the largest closed-end fund IPO since the Eaton Vance Tax-Managed Global Diversified Equity Income Fund, which raised $6.03 billion in February 2007, according to Ipreo, a New York-based provider of market data.
Pimco’s $1.36 billion Dynamic Income Fund, its closed-end fund that started last year, has returned 29 percent including reinvested dividends since its inception on May 24, compared with 12.5 percent for the Bank of America Merrill Lynch U.S. High Yield index.
DoubleLine’s Income Solutions Fund “may invest in debt securities and other income-producing investments of any kind,” including an unlimited amount of securities rated below investment grade, according to a Jan. 15 filing. It also intends to borrow money through reverse-repurchases agreements, dollar-roll transactions, loans or lines of credit.
Mark Porterfield, a Pimco spokesman, and Loren Fleckenstein, of DoubleLine declined to comment on the new closed-end funds.
“Many investors are searching for income, they’re looking at closed-end funds as a good way to receive a more attractive yield,” said Cecilia Gondor, executive vice president at Miami-based Thomas J. Herzfeld Advisors Inc. “Closed-end funds tend to use more leverage than open-end funds because they don’t have to worry about cash inflows and outflows.”
Unlike with mutual funds, money for closed-end funds is raised through an IPO. The number of shares outstanding is then fixed, with investors buying and selling units of the fund on the stock exchange.
Blackstone’s GSO Strategic Credit Fund obtained a credit line with up to $425 million available, according to a Dec. 21 release, making its potential total size $1.28 billion based on current net asset value.
KKR & Co. filed last year to create the Alternative Corporate Opportunities Fund, which has a closed-end structure and will invest in “special situations, direct lending and mezzanine finance,” co-chairman Henry Kravis said in a Dec. 4 presentation.
The Fed has held its benchmark interest rate between zero and 0.25 percent since December 2008, seeking to ignite an economy wounded by $2.1 trillion in global writedowns and credit losses from the financial crisis that began in 2007.
While the U.S. unemployment rate has declined to 7.8 percent from 10 percent at its 2009 peak, the average estimate of 83 economists surveyed by Bloomberg is for growth this year of 2 percent following 2.3 percent in 2012.
Prices on speculative-grade bonds have soared to an unprecedented 105.9 cents on the dollar, according to Bank of America Merrill Lynch index data. Yields on the index fell to 6.41 percent as of Jan. 25 from last year’s high of 8.46 percent last Jan. 3.
Closed-end funds have been able to take advantage of the record-low borrowing costs to increase returns, even as yields plunge, attracting individuals who rely on interest to pay monthly bills, said UBS’s Marfatia.
“A lot of the closed-end funds pay monthly dividends,” Marfatia said. “It’s all about income.”