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Junk bonds drawing more investors despite the risks

Historically low interest rates are nudging investors into riskier investments such as junk bonds. Some analysts see signs the market could be overheating.

December 13, 2012|By Andrew Tangel, Los Angeles Times
  • Westlake Village home builder Ryland Group rushed into the bond market with a $250-million offering in September. Above, houses under construction at the Ryland Homes Vista Heights development in Rancho Cucamonga last month.
Westlake Village home builder Ryland Group rushed into the bond market… (Patrick T. Fallon / Bloomberg )

NEW YORK — Low interest rates pushed down by the Federal Reserve have opened a spigot of easy money to companies with less than sterling credit.

The Fed, which signaled Wednesday that it would aggressively keep rates low until unemployment fell below 6.5%, has been pumping billions of dollars into the economy. And the historic rate drops are nudging investors into riskier investments.

One place that has attracted investors is the debt of companies with non-investment-grade, or "junk," credit ratings. Companies have been all too eager to oblige, taking advantage of the situation by issuing millions of dollars in junk bonds.

"It's really been startling," said Bonnie Baha, head of global developed credit at the bond fund Doubleline Capital in Los Angeles. "So much money has been flowing into this sector."

For example, the Westlake Village home builder Ryland Group rushed into the bond market with a $250-million offering in September. Ryland, like other home builders, saw its finances hurt and credit ratings dented during the mortgage crisis and its aftermath. But the company's low credit rating didn't deter investors in the offering, which came with a relatively low interest rate of 5.38% and few strings attached.

Ryland plans to use the proceeds to buy land in Southern California, Texas and Florida and elsewhere next year as it expands and bets the housing market continues to recover.

"With all these issues we're facing now, let's take the money when we know we can get it," said Gordon Milne, chief financial officer, describing Ryland's decision.

Although investors have been devouring high-yield bonds this year, some analysts see signs the market could be overheating and are warning that investors could get burned when the tide reverses.

Yet investors seem to be buying bonds from nearly any company, without much regard to financial health or protections for investors, Baha said. "The quality of some of the deals that have come to market this year has been pretty suspect," she added.

Investors shoved $27.9 billion into high-yield bond funds this year as of October, almost twice as much as the $14.4 billion put into those funds in all of 2011, according to Morningstar Inc.

Interest rates on junk bonds — which soared to about 18% at the height of the financial crisis in 2008 — have fallen below 6%, according to a high-yield index tracked by KDP Investment Advisors.

As the Fed's monetary stimulus programs — known as quantitative easing — have pushed interest rates closer to zero, investors have put their money in riskier assets including stocks, real estate or bonds issued by developing countries.

"We're in an artificially low-rate environment," Baha said. "Everyone is desperate for whatever kind of return they can get."

The river of cash into junk bonds may be a lifeline to some companies.

Take Energy Future Holdings Corp., a Texas energy company. A bond analyst at KDP Investment Advisors Inc. wrote in a recent note that the company's "capital structure is unsustainable" and the company would "likely see defaults within the next two years," yet Energy Future Holdings would probably tap the junk bond market again in 2013. The company declined to comment.

Investors' frenzy for yield has led to loose terms for companies issuing junk bonds. Deals are coming with fewer covenants, or restrictions on how companies can use their cash or dispose of assets and whether they can issue more bonds.

"So many issuers are selling covenant-light bonds because they can — it's as simple as that," Adam Cohen, who heads the credit research firm Covenant Review, wrote in an email.

Some observers have begun sounding the alarm.

"This all presents, to me, a pretty big risk in the market," Michael Gitlin, director of fixed income at T. Rowe Price, said during a recent presentation. "When you start seeing things like this, like you did in '06 and '07, you should start being concerned."

Corporate default rates are relatively low, however.

The trailing 12-month default rate on speculative-grade corporate bonds declined to 2.7% in November, from 2.8% the previous month. But that default rate could rise to 3.7% by September 2013, according to ratings company Standard & Poor's.

An uptick in corporate defaults if the economy worsens could rattle investors, leading to a sell-off and higher borrowing costs for companies with junk ratings.

"At some point something's got to give," Baha said.

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