Junk bonds are growing popular, turning riskier

Junk bonds are living up to their name again.

Companies with junk credit ratings have been increasingly issuing bonds for riskier purposes that could hinder their ability to pay back bondholders.

Demand for junk bonds has touched record levels this year as investors reach for their rich yields, a stark contrast to the meager returns available on Treasury securities and money market accounts. But the voracious demand has allowed companies to easily raise money for things that may actually end up weakening them.

For most of this year, the bond issuers were at the higher end of the junk credit-rating spectrum, and were using the money to refinance old debt at lower interest rates, thereby solidifying their economic footing. That made many analysts feel more comfortable about the flood of new junk bonds.

But in recent weeks, there has been a decline in the average credit rating of the companies issuing junk bonds, to C ratings nearer the bottom of the junk rankings from the BB ratings at the top. And companies have been using more of the proceeds for the sorts of risky projects that were common before the financial crisis and in the go-go days of the 1980s — paying dividends to private equity owners and financing mergers and leveraged buyouts.

Jo-Ann Stores and Petco, for instance, both with junk ratings of CCC, sold a combined $875 million of bonds this month, with some of the money set to quickly leave the companies through dividend payments to their private equity owners. Many analysts say that the practice can hurt the financial health of the companies by increas- ing their regular interest payments to bondholders without strengthening the underlying business.

“Companies that were having difficulty coming to the market, or who want to be more aggressive, have now gotten the opportunity to do so,” said Kingman Penniman, the founder of a junk bond research firm. “Clearly it’s a disturbing trend.”

The shift is particularly worrying to Penniman and others because so much of the money going into these bonds is coming from individual investors who may be unaware of the declining credit quality.

Over the first three quarters of the year, retail and institutional investors piled into junk bonds with equal alacrity. The record for junk bonds issued in the United States a single year was broken on Oct. 18, and now stands at $293 billion, compared with $249 billion in all of 2011, according to Dealogic. But in recent weeks, as the bonds have grown risker, figures from the data company EPFR show that wiser institutional investors have begun to shift money out of junk bonds, as individual investors have continued to pour in. Retail investors added about $2.1 billion to their portfolios in the first three weeks of October, compared with a net outflow of $256 million from institutional investors.

Because bonds, whether investment-grade or junk, do not lose all their value when a company goes bankrupt, they carry a greater aura of safety than a company’s stock, which can be wiped out in a Chapter 11 filing. This year, retail investors have put about $22 billion into junk bond funds, compared with the $8.3 billion that went into these funds in 2011 from all sources, according to EPFR.

Because of

the

minuscule

interest rates being offered on other types of bonds, some analysts say that junk bonds still represent a good deal. Even as the interest rates on junk bonds have fallen to their lowest levels ever, the yields on Treasury bonds have fallen even more quickly. The total return on high-yield bonds this year has been 12.8 percent, compared with 9.6 percent on investment-grade bonds and 14.1 percent on the Standard & Poor’s 500-stock index, according to the Royal Bank of Scotland.

But Carl Kaufman, who buys bonds for Osterweis Capital Management, said he is having to be much more selective in which junk bonds he buys, to avoid those that “are going for no productive purpose.”

Among the bonds that worry investors are those being used to pay for acquisitions, a riskier pursuit than the refinancing that dominated earlier this year. Some private equity companies are raising money for new leveraged buyouts, which can load the acquired company with debt. David’s Bridal, for example, borrowed $270 million, rated CCC by Standard & Poor’s, in early October to finance its sale from one private equity owner to another.

Then there are the bonds issued to pay dividends to a company’s private equity owners. The hospital company HCA borrowed $2.5 billion on Oct. 16, in part to make payments to its three private equity owners — Kohlberg Kravis Roberts, Bain Capital and Merrill Lynch Global Private Equity. Penniman said that deals like this, in isolation, increase a company’s debt and make it harder to fulfill its obligations to bondholders.

A spokesman for HCA, Ed Fishbough, said: “We’re pleased with the response to our offering” from investors, and also with the company’s debt levels.

The trend that worries investors most is the rise of bonds that allow the borrower to skip cash interest payments if it hits financial trouble, removing one of the most attractive features of bonds: the guaranteed fixed income.

“It is an expression by the company that we’re not sure we’re going to be making enough money to pay the interest for the next few years,” said Adam Cohen, the founder of Covenant Review, a credit research firm.