Junk Buyers Jockey for Worst in Race to Bottom: Credit Markets

Bond buyers have never been paid so little to lend to the riskiest junk-rated companies, yet they’ve been gobbling up their debt at an accelerating pace.

Average yields on debt worldwide graded CCC and below fell to a record-low 8.58 percent this week, a rate investors were getting just three years ago from BB rated companies on the cusp of investment-grade, according to Bank of America Merrill Lynch index data. Sales of the bonds increased to 18 percent of total junk-bond issuance in April, the most in eight months and above the average of 13 percent over the past decade, data compiled by Bloomberg show.

The rush for high-yielding assets in the sixth year of the Federal Reserve’s easy-money policies is leaving debt markets wide open for companies that had been teetering on distress. Clear Channel Communications Inc., the radio broadcaster with debt that’s 12 times its earnings, more than doubled the size of a bond sale last month, while Greece’s Yioula Glassworks SA sold securities this week after postponing an offering in February.

“That’s a function of the desperate search for yield,” said Martin Fridson, the chief investment officer at investment firm Lehmann, Livian, Fridson Advisors LLC in New York, who started his career as a corporate-debt trader in 1976. “Many CCC and lower issues that ought to be trading at distressed levels are not as a result.”

Weaker Protections

Of the $75.5 billion in high-yield bond offerings worldwide last month, $12.8 billion were rated or expected to be rated Caa1 or lower by Moody’s Investors Service, Bloomberg data show. The sales exceeded the $9.4 billion issued in the entire first quarter.

Investors aren’t only buying the debt at the lowest-ever yields, but agreeing to terms that leave them with some of the weakest protections since Moody’s began tracking them in January 2011.

The strength of those bond covenants, such as restrictions on leverage and cash disbursements, deteriorated to 4.19 last month for junk bonds sold in North America, from 4.13 in March, Moody’s said May 13 in a report. The figure reversed course after improving from 4.36 in February, its weakest level on record. A higher score denotes weaker covenant quality on a scale from 1 to 5.

Risks ‘Building’

“It’s not a bubble, but some risks are building up through issuance by weaker companies,” Axel Potthof, the Munich-based head of European high yield at Pacific Investment Management Co., said in a telephone interview. “Some of these companies have failed several times in the past to come to the high-yield market, but now they can find interested investors and can sell bonds.”

Glasstank, a unit of Greek glass container manufacturer Yioula Glassworks, which postponed a planned bond sale in February because of “market conditions,” this week sold 185 million euros ($254 million) of five-year notes yielding 10.875 percent and expected to be rated Caa1 by Moody’s, Bloomberg data show. That compares with an average yield-to-worst of 3.49 percent on the Bank of America Merrill Lynch Euro High Yield Index.

“There is a lot of risk, it is a CCC credit story, but you’re getting paid,” said Jon Brager, a senior credit analyst at Hermes Fund Managers in London, which has 26.9 billion pounds ($45 billion) under management and holds the bonds. “It’s three times as wide as the index.”

Premium Narrows

High-risk, high-yield bonds are rated below Baa3 by Moody’s and lower than BBB- by Standard & Poor’s. S&P describes securities ranked in the CCC tier as “currently vulnerable to nonpayment” and for which issuers are dependent on “favorable business, financial and economic conditions” to meet their commitments.

Demand for the lowest-ranked debt has narrowed the premium that buyers earn from it instead of bonds rated in the BB tier, which is just below investment grade. The gap has declined to 4.87 percentage points from last year’s high of 5.88 percentage points, index data show. The difference reached a more than two-year low of 4.64 percentage points last May.

“Finding pockets of value is more difficult and investors are compensated less for taking on extra risk,” Anthony Valeri, a market strategist in San Diego with LPL Financial Corp., wrote in a May 13 report.

Defaults Decline

Buyers of the debt are being comforted by a default rate that’s expected to fall to less than half the historical average by year-end. The trailing 12-month global speculative-grade default rate was 2.4 percent in April and will close the year at 2.3 percent, Moody’s analysts led by Albert Metz wrote in a May 8 report. That compares with an average of 4.7 percent.

The extra yield investors demand to own the riskiest bonds instead of government debentures, which reached a more than six-year low of 7.5 percentage points last month, was 7.69 percentage points on May 9, Bank of America Merrill Lynch index data show. The spread compares with an average of 12.21 percentage points since the end of 2008, index data show.

A unit of Clear Channel Communications issued $850 million of 10 percent, 3.75-year notes last month after more than doubling the size of its sale, Bloomberg data show. The debt, rated Ca by Moody’s, the second-lowest junk rating, was issued with terms that lacked protections of other high-yield securities, Moody’s said.

Trilogy International Partners LLC, a Bellevue, Washington-based wireless provider, has $450 million of 10.25 percent, CCC rated bonds due August 2016, which can be called at 102.563 cents on the dollar starting Aug. 15, Bloomberg data show.

“I get calls weekly from investment bankers,” Drew Davies, Trilogy’s chief financial officer, said in a telephone interview. “Once you get below two years, people are expecting you to refinance.”

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