Wednesday, November 15, 2006

Around the Markets: Bad credit shines, but will it last?

NEW YORK: The worst are now first in the U.S. market for corporate bonds.

Securities with the lowest credit ratings gained 33 percent this year after losing 16 percent in 2005, according to an index compiled by Merrill Lynch. Bonds of Refco and Delphi, which stopped paying interest when bankruptcy proceedings began 12 months ago, appreciated more than $900 million this year, while below-investment-grade bonds on average gained 8.6 percent.

Hedge funds, fortified by $110 billion in new money from institutional investors, are snapping up the highest-yielding, highest-risk junk bonds, encouraged by an economy strong enough to reduce defaults without accelerating inflation, according to Hedge Fund Research in Chicago. So-called distressed debt funds attracted $2.7 billion during the third quarter, the biggest three- month inflow since at least 2003, the group said.

"Hedge funds are increasing institutional demand for yield," said Tom Connolly, co-head of leveraged finance and one of two Goldman Sachs executives overseeing origination and distribution of high-yield, high-risk bonds and loans. "The leveraged debt market has seen explosive growth."

Bonds of Refco, the New York futures broker that filed for protection from creditors in October 2005, have more than doubled in price this year. Refco filed for bankruptcy a week after disclosing that its former chief executive, Phillip Bennett, had concealed $430 million in debt. Bennett has pleaded not guilty to U.S. fraud charges and is awaiting trial.

Delphi, based in Troy, Michigan, the world's biggest auto parts maker, gained 58 percent in the bond market during the past six weeks. The company filed for bankruptcy in October 2005. By contrast, the best returns in the stock market this year have been telecommunications shares, which drove up the Nasdaq telecommunications index 23 percent.

For investors in the riskiest high- yield bonds, it does not get much better. The U.S. unemployment rate fell to a five-year low of 4.4 percent in October and the inflation rate dropped to 2.1 percent in the 12 months that ended Sept. 30, down from 3.8 percent the previous month.

Just 21 borrowers failed to pay on bonds worth $7 billion in the year through October, compared with 28 defaults on almost $20 billion during the same period of 2005, according to data compiled by Moody's Investors Service.

"Defaults weren't supposed to go down, and they did go down," said Martin Fridson, the publisher of the Distressed Debt Investor in New York and chief executive of the high- yield research firm FridsonVision. "You can argue that credit risk actually declined instead of increasing."

Standard & Poor's estimates that 0.4 percent of company bonds are in distress, the lowest level since 1998.

"A lot of these companies are in adequate shape for this economy," said Eric Misenheimer, who manages high-yield bonds at J.&W. Seligman in New York, noting that junk bonds "are definitely attractive."

The lowest-rated companies have had little trouble raising money. Continental Airlines last week raised $200 million by selling 8.75 percent senior unsecured notes due in 2011, its first such offering since 1998. The company has a highly speculative rating from Moody's.

"There is an enormous amount of capital in the market," said Jonathan Rosenthal, a partner at Saybrook Capital in Santa Monica, California, who represented creditors in the bankruptcy of United Airlines.

A weakening U.S. economy may stunt the rally in distressed debt. Growth in the third quarter was the slowest since 2003 as the U.S. housing market slumped. The billionaire investor Wilbur Ross Jr., said last week, "It's inevitable that we will see higher default rates" after announcing a plan to help invest $685 million in bankrupt companies for a group formed by Goldman.

The surge in prices of distressed debt bonds may be a sign that the market has reached a peak, said Marilyn Cohen, as president of Envision Capital Management in Los Angeles. "For anyone to say this isn't overdone, I think is insane," she said.

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