Money Managers Finding It Hard to Resist Junk

After years of paltry yields in the high-yield junk bond market, of all places, investors are back in the sector with a vengeance, taking advantage of rising coupons.

The recent tumble in classically risky assets such as junk bonds has produced yields that some money managers just can't pass up.

It's the first time in years that I have assigned all of my analysts a couple of credits to look at, said Andrew Feltus, portfolio manager at Pioneer Investments in Boston.

Added Mark Vaselkiv, manager of the T. Rowe Price High-Yield Fund: We're definitely finding things to buy.

Spreads on junk bonds, or corporate debt rated below Baa3 by Moody's Investors Service and triple-B-minus by Standard & Poor's, had widened over Treasuries so much that investors like Feltus and Vaselkiv started to look at them seriously in recent weeks. Tighter global interest-rate policies and emerging inflationary pressures have pushed yields up and prices down.

As evidence that investors are putting money to work in the junk-bond market, premiums have narrowed on a major benchmark. The average spread on the Merrill Lynch Master II High-Yield Index is 331 basis points over Treasuries for a yield of 8.60 percent.

In comparison, the spread on the index one year ago was 371 basis points over Treasuries, but for a yield of only 7.80 percent. The spread represents the premium investors demand to compensate for the risk of holding junk-market instruments.

MANAGERS GORGE ON NEW DEALS

A spate of recent junk-bond deals have sported more yield than seen in years to attract investors. Nortel Networks Corp., the telecommunications gear maker, Baker & Taylor, the biggest book supplier to libraries, and National Mentor Holdings, provider of home and community-based services, all had to cough up double-digit coupons to attract buyers.

Other issuers have found the market too dicey. FleetPride Corp., the largest U.S. independent heavy-duty truck-parts distributor, pulled a $150 million junk offering, and Armor Holdings Inc., a manufacturer of security products, yanked a $400 million deal.

T. Rowe's Vaselkiv bought the recently issued 8.625 percent senior notes due August 1, 2016, of Windstream Corp., a local telephone business being spun off by Alltel Corp. Windstream's $1.75 billion 8.625 percent 10-year notes, which are rated Ba3 by Moody's and double-B-minus by S&P, priced at 97.5 cents on the dollar to yield 9 percent.

It's an old-fashioned business with a solid credit-rating, which priced at a discount and attractive yield, says Vaselkiv. He bought the securities at an average cost of 98.75 cents on the dollar. Now the notes are trading at 102.50, according to KDP Advisors.

Christopher Towle, partner and portfolio manager at Lord Abbett, bought recently issued bonds by Chesapeake Energy Corp., adding to his holdings in the oil and gas company.

Chesapeake, rated Ba2 by Moody's and BB by S&P, offered $500 million of 7.625 percent senior notes maturing in seven years. In comparison, a 10-year U.S. Treasury note is yielding less than 5.15 percent.

There's no doubt you can find value in this market, said Towle, adding that credit quality is still improving in the junk sector. Indeed, corporate earnings continue to grow at a double-digit pace, corporate balance sheets are flush with cash, and the default rate remains low.

Despite recent market turbulence, the distress ratio, which Merrill defines as a proportion of credits in the High-Yield Master index outyielding the 10-year Treasury note by 1,000 basis points or more, was unchanged at 2.8 percent in June. That is a nine-year low.

EXISTING ISSUES ARE ALSO APPEALING.

Vaselkiv swapped out of the General Motor's Corp.'s GMAC 8 percent bonds due 2031 that he bought earlier this year at an average price of 90 cents on the dollar, which rose to more than 105, and into shorter GMAC bonds. He also bought GM's 5.25 percent convertible preferred securities due 2032, which were issued in $25 par amounts. They now trade at about 18.50, for a yield to its put date in 2014 of 10.285 percent, according to Morgan Stanley's ConvertBond.com.

You get the upside potential if the stock rallies - and even if you don't, you can still put it back in 8 years at $25 - with a nice pick up in yield, says Vaselkiv. GM shares are the best performers this year in the Dow Jones industrial average and sixth best in the S&P 500, rising 51.6 percent.

Bob Adler, president of AMG Data Services, said June's sell-off in classically risky assets from junk bonds to emerging markets securities triggered an exodus out of the mutual funds that invest in them. Last week, however, investors poured $98 million in high-yield funds, the first inflow into these funds in four weeks and the largest since December 2005, said Adler.

Adler said the value of these portfolios has gone up by a greater amount than at any time since last July, which could be providing investors the impetus to move money into junk.

Finally, Adler said, a huge cash build of about $67.5 billion in May and June could have been working its way into these funds with yields rising and the added opportunity for capital appreciation.