Fed Joining in Alarm Over Distortion It Enabled: Credit Markets

A Federal Reserve governor is joining those warning that junk-debt investors are poised for losses, while his institution’s policies spur them to keep buying the debt.

Yields on a record 38 percent of the $1.1 trillion of notes sold by the neediest U.S. borrowers were trading below the 10-year average rate for investment-grade debentures last month, Barclays Plc data show. Investors poured a record $1.3 billion into U.S. leveraged loan funds last week as covenants on the debt weaken the most ever.

The central bank’s policy of keeping benchmark borrowing costs at about zero for a fifth year is pushing investors into riskier debt, even as Fed Governor Jeremy Stein warns that the market for speculative-grade debt may be overheating. While U.S. prosecutors are suing Standard & Poor’s for deliberately failing to provide warnings against losses on collateralized debt obligations before the credit crisis, the government’s stimulus is fueling demand for similar products now.

“No matter how loud the chorus gets that this is crazy, the bulls are going to continue to run because there’s nowhere else to put money in fixed income,” said David Tawil, the co-founder of Maglan Capital LP, a distressed-debt hedge fund that manages about $50 million. “If I’m saying now that the deals are getting laughable, if things don’t change, six months from now the deals are going to be stupid.”

Covenant-Lite Boom

Sales of so-called covenant-lite loans represented about 55 percent of the debt sold to non-bank lenders in January, the greatest proportion ever, Morgan Stanley analysts wrote in a Jan. 25 report. Covenant-lite debt does not carry lender protection such as financial maintenance requirements.

Firms from Credit Suisse Group AG to Symphony Asset Management LLC sold $8.7 billion of collateralized loan obligations in January, the busiest month of issuance since November 2007, according to JPMorgan Chase & Co. CLOs pool high-yield, high-risk loans and slice them into securities of varying risk and return.

Borrowers are selling speculative-grade bonds that have the weakest covenants in at least two years, according to Moody’s Investors Service. About $506 billion of dollar-denominated junk bonds are trading above the price that their issuers may buy them back at later, limiting potential gains, Morgan Stanley data show.

Rich ‘Valuations’

“Valuations are rich,” said Morgan Stanley credit strategist Adam Richmond in New York. “The pendulum is swinging in favor of issuers. It does seem like the peak in credit quality is probably behind us.”

Leveraged loans and high-yield bonds are rated below Baa3 by Moody’s and lower than BBB- at S&P.

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. rose, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, increasing 0.6 basis point to a mid-price of 90 basis points at 11:51 a.m. in New York, according to prices compiled by Bloomberg.

The index typically rises as investor confidence deteriorates and falls as it improves. 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.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings added 0.2 to 116.3.

Rate Swaps

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.47 basis point to 15.85 basis points as of 11:52 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

Bonds of Fairfield, Connecticut-based General Electric Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.8 percent of the volume of dealer trades of $1 million or more, at 11:52 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

More than one-third of dollar-denominated junk bonds were carrying yields below 4.75 percent, the 10-year average rate for investment-grade bonds, on Jan. 31, Barclays data show. That’s up from about 2 percent of the notes carrying such low yields in September 2011, according to the data.

Junk Yields

“High-yield is as overbought as I have ever seen it,” Dan Fuss, whose $22.7 billion Loomis Sayles Bond Fund beat 98 percent of its peers in the past three years, said last month in an interview in London. “This is absolutely, from a valuation point, ridiculous.”

Yields on the notes globally plunged to 6.31 percent on Jan. 25 from a peak of 23.2 percent in December 2008 after investors funneled $72.4 billion last year into funds that buy the debt, according to the Bank of America Merrill Lynch index and EPFR Global data.

Investors deposited $12 billion into floating-rate funds in the past 34 weeks, according to Bank of America Corp. Last week’s unprecedented inflow helped boost the funds’ net assets by 6 percent year to date and offset the $1.3 billion of withdrawals from global junk bonds in the period.

Stein’s Warning

“We are seeing a fairly significant pattern of reaching-for-yield behavior emerging in corporate credit,” the Fed’s Stein said in a Feb. 7 speech in St. Louis. If the observation is accurate, he said, “it does not bode well for the expected returns to junk bond and leveraged-loan investors.”

Investors bought $100 billion of loans last year that didn’t restrict the borrowers’ debt to earnings or interest expense, JPMorgan strategists led by Peter Acciavatti wrote in a report last month. That exceeds the prior high of $99 billion in 2007. Covenant-lite loans now account for a record 29 percent of the outstanding debt, topping the 18 percent share before the credit crisis.

Junk-rated borrowers sold debentures that received an average covenant score of 4.15 in November on a scale from one to five, with five being the least restrictive, according to Moody’s Covenant Quality Index. That was the weakest level in data going back to January 2011.

“It’s crazy,” Maglan’s Tawil, who said his fund gained 41 percent last year, said by phone from New York. “The government is going to continue to fuel this.”

Low Rates

The Fed has held benchmark interest rates at about zero since December 2008 and plans to purchase $85 billion in bonds to ignite an economy still recovering from the worst financial crisis since the Great Depression. The government intends to suppress borrowing costs for the world’s largest economy as long as unemployment remains above 6.5 percent and inflation remains no more than 2.5 percent.

The jobless rate rose to 7.9 percent last month from 7.8 percent in November and December.

The U.S. is seeking to galvanize an economy wounded by $2.1 trillion in global writedowns and credit losses from the financial crisis that began in 2007. The U.S., in a lawsuit filed Feb. 4 in federal court in Los Angeles, is alleging that S&P defrauded investors by failing to accurately reflect the risk on mortgage-backed securities and CDOs because it was afraid of losing business.

There were about $54 billion of CLOs created last year, quadrupling the $12.3 billion formed in 2011, according to S&P’s Capital IQ Leveraged Commentary & Data. Wells Fargo & Co. is forecasting as much as $70 billion in CLO origination this year.

Of the $925 billion of junk bonds outstanding, 55 percent are trading above the price at which issuers can repurchase them later, according to a Morgan Stanley analysis using the Citi High Yield Market Index.

“The idea here is to keep rates low enough for a long enough time that the economy builds up enough steam,” Tawil said. “I don’t know if our economy is capable of picking up the steam necessary.”

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