Exotic New Junk Bonds are Fraught with Risk

 

“Signs and wonders” are pointing to a new bubble brewing in corporate debt and investors should be wary. According to a January 6 Bloomberg article by Bryan Keogh and Shannon D. Harrington (“Treasurers Embrace Pay-in-Kind Bonds as Ghost of Lehman Fading”), companies are (i) issuing bonds that pay interest in new debt rather than cash, (ii) using the proceeds to pay dividends to their owners rather than for operations or expansion, (iii) asking their lenders to change the terms of their existing debt agreements to permit this, and (iv) increasing the amounts of offerings if investors want more. Such risky offerings have not been seen since 2007, before Lehman Brothers declared bankruptcy and the credit markets froze.

One company offering such bonds is Wind Acquisition Holdings Finance SpA, the parent of Italy’s third-largest mobile phone company. “Six months ago I wouldn’t have imagined being able to do this deal,” said Karim-Michel Nasr, head of corporate development in Paris at Weather Investments SpA, Wind’s holding company.

But safe assets like Treasuries are paying next to nothing and investors no longer see the beast of the apocalypse looming. They are letting their guard down. Speculation that companies will have less difficulty making payments has led investors to accept lower interest rates and looser borrowing terms. The extra yield demanded on junk bonds instead of Treasuries narrowed to 6.39 percentage points at the end of 2009 from almost 19 percentage points on March 9, Merrill Lynch indexes show.

The flood of investor demand follows a record return of 58% in junk bonds last year, as measured by Bank of America Merrill Lynch indexes. U.S. sales of $162 billion beat the all-time high of $149 billion in 2006, Bloomberg data show.
Some experts are not letting their guard down. The rally means “choices are limited and the value is diminishing,” according to Bill Gross, who runs the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co. Gross said that he’s growing more concerned about corporate bonds because the economic recovery isn’t assured. The firm is “more cautious,” Paul McCulley, a money manager and member of the firm’s investment committee, said Jan. 4 in his 2010 outlook posted on Pimco’s Web site.

“Very lenient terms” show “there’s definitely been a shift back to the issuer,” said Edward Altman, a finance professor at New York University’s Stern School of Business. “I don’t see the fundamentals justifying it.”

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