Tapering plan drives investors into riskier debt

August 18, 2013 6:21 pm

Tapering plan drives investors into riskier debt

By Stephen Foley and Vivianne Rodrigues in New York

The Federal Reserve’s plan to end quantitative easing, in part to prevent financial bubbles, is in fact driving investors into riskier corners of the debt markets.

While the safest bonds have sold off hardest since Ben Bernanke, Fed chairman, set a timetable for tapering its monetary stimulus, the best-performing fixed-income assets have been the lowest-rated junk bonds.Money has also poured into loans in the past three months, with the result that many borrowers no longer have to provide customary investor protections.

“Investors are so afraid of rising rates that they are trading off rates risk by taking on more credit risk,” said Ashish Shah, head of global credit at asset management group AllianceBernstein.

Junk bonds rated triple-C, the lowest tier possible, are the only corporate bonds to have generated positive returns since Mr Bernanke’s June 19 press conference, when he said the Fed would most likely start scaling down its Treasury and mortgage purchases this year and wind them up by the middle of next.

Riskier bonds tend to offer higher interest rates and so repay their purchase price more quickly – a measure called “duration” – something that has become critically important in a rising interest rate environment. Longer duration bonds fall more sharply when market interest rates rise.

Investment grade bonds have lost 1.3 per cent and double-B rated junk bonds have shed 0.8 per cent since June 19, compared to a positive return of 0.9 per cent for the triple-C class.

The extra yield, or spread, that triple-C investors are demanding over risk-free Treasuries has narrowed by 20 basis points over the same period, compared to 5 basis points for investment grade corporate bonds.

Bankers have been emboldened by the demand for high-yielding investments to seek more advantageous terms for borrowers.

Matt Duch, a portfolio manager at Calvert Investments, said there had been an increase in borrowers seeking to add high leverage and “payment-in-kind toggle” deals, which give borrowers the option to pay lenders with more debt rather than cash.

“The strong demand for low-rated high yield could be fostering a generation of paper with subpar structures,” he said. “That could definitely be a problem in the future should defaults pick up or financing suddenly become less available.”

Some of the most aggressive deal structures are being proposed in the loan market, which is used for financing leveraged buyouts. There have now been 61 consecutive weeks of inflows into mutual funds and exchange-traded funds specialising in loans, according to Lipper, adding up to $39.1bn of new money chasing investment opportunities. Some $11.6bn has been added since June 19.

Because loans offer a floating rate of interest, they are seen by investors as insulated from the risks of rising rates as the Fed tapers QE.

The US software group BMC, which was acquired by a private equity consortium led by Bain Capital and Golden Gate Capital, this month sold $5.86bn of debt with only light covenant protections for investors and with an unusual provision giving more freedom to sell assets before repaying lenders.

The use of “covenant-lite” loans has re-accelerated since Mr Bernanke’s remarks, accounting for 58 per cent of all loan issuance so far this month. That puts August on course to be the second highest month ever, after January 2013, according to S&P Capital IQ.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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