Record junk bond sales raise concerns of future bust

NEW YORK — Wall Street banks are selling junk bonds at a record pace — raising concerns they are selling debt that may be poised to lose value.

The banks spent more than $93 billion dealing with costs from the 2008 credit crisis, including lawsuits and fines for allegedly misleading investors about mortgagebacked products.

This time is different, bankers say.

Wall Street banks have underwritten $ 89.6 billion of high-yield debt so far this year, up 36 percent from the same period in 2012, according to data compiled by Bloomberg.

Last year’s $433 billion of sales was an all-time high for the asset class and produced about $6 billion in fees, the data show.

J PMorgan Chase, Deutsche Bank Citigroup and Bank of America are leading firms benefiting from growth in a market where the average underwriting fee is almost three times as big as for selling more creditworthy bonds.

Meanwhile, investors poured $33 billion into mu- tual funds and exchangetraded funds dedicated to junk bonds last year, 55 percent more than in 2011, according to Morningstar Inc.

The risks to investors are less about the bonds’ creditworthiness and more about benchmark government borrowing rates that eventually must rise after falling to a three-decade low, bankers say. The pace of leveraged buyouts, which issue junk bonds to fund acquisitions, is nowhere near the levels in 2006 and 2007, bankers say. Much of the new debt has been issued by companies refinancing at lower rates instead.

“Investors and underwriters in this market are showing credit discipline,” said Marc Warm, New York-based head of U. S. high-yield capital markets at Credit Suisse Group, which ranks sixth among high-yield bond underwriters globally, according to data compiled by Bloomberg. “The rate environment is probably more of a risk today.”

To stoke economic growth, the Fed has kept short- term borrowing rates close to zero for more than four years and purchased U.S. Treasuries and mortgage-backed bonds to drive long-term borrowing rates to a record low.

Falling interest rates have increased demand for higher-yielding debt, boosting prices on dollardenominated junk bonds to a record 105.9 cents on the dollar last month, according to Bank of America Merrill Lynch data. As yields have collapsed to 6.54 percent from a peak of 22.7 percent in late 2008, junk bonds have become more sensitive to the risk that underlying government bond yields could increase.

The extra yield that investors demand to own junk bonds over govern- ment debt, known as the spread or risk premium, has contracted by 16.69 percentage points since 2008 to 5.24 percentage points, according to the Bank of America Merrill Lynch Global High-Yield Index.

While economists surveyed by Bloomberg expect 10-year Treasury yields to rise by less than a percentage point through the first half of 2014, some investors already are preparing for higher rates by funneling record amounts of cash this month into leveraged loans, which are

tied to floating-rate benchmarks. The world’s biggest corporate-bond buyers also are seeking refuge in shorter-maturity notes. So are some banks.

PNC Financial Services Group president William Demchak, a former JPMorgan executive, said the Pittsburgh- based bank is sticking to short-term investments in its fixedincome portfolio to avoid losses when interest rates climb. He said he expects long-term rates to swing higher before the Fed starts raising rates.

“The long end of the curve could get out of their control,” Demchak, who will become PNC’s CEO in April, said in a telephone interview. “That’s everybody’s fear. I think that’ll happen sooner than people expect.”

Wall Street’s biggest banks have benefited most from fees tied to junk-bond sales, with the top 10 underwriters capturing 45 percent of assignments last year, according to data compiled by Bloomberg. JPMorgan, first every year starting in 2009, is leading 70 firms in the global market this year, the data show. Frankfurt- based Deutsche Bank and New York-based Citigroup are ranked second and third.

The Treasury Borrowing Advisory Committee, a group of senior bankers and investors whose chairman is JPMorgan’s Matthew Zames, gave a presentation to Fed Chairman Ben Bernanke this month in which they warned that the central bank’s policies may be inflating bubbles in speculative-grade bonds and other asset classes, according to people with knowledge of the discussions. Bernanke played down those concerns, the people said. Michelle Smith, a Fed spokeswoman, declined to comment.

Debt underwriting, including both investmentgrade and junk, was among the fastest-growing revenue lines for the world’s nine biggest investment banks last year, contributing 40 percent to 63 percent of advisory and underwriting revenue, company reports show. Banks earned an average 1.4 percent fee on dollar- denominated high-yield debt issued last year, almost triple the average 0.54 percent fee on all investment-grade issues, according to data compiled by Bloomberg.

$600,000 BONUSES

Managing directors in debt capital-markets units at the top banks were awarded bonuses ranging from $600,000 to millions of dollars, said Jeanne Branthover, head of the financial-services practice at Boyden Global Executive Search Ltd., a New York- based recruiting firm. Those payouts don’t compare with what was available before the 2008 crisis because compensation is tied to company performance more than it used to be.

“No longer just because you’re in a certain area of the firm do you get an outrageous bonus,” Branthover said. “They’re not making $10 million. They’re making good money, big money, but not what it used to be.”

The junk-bond market was developed in the 1970s to help finance companies unable to sell investmentgrade debt. Throughout most of the market’s history, interest rates have declined, helping boost bond prices. Yields on 10-year Treasury notes, the benchmark against which junk bonds are often priced, have dropped to 1.88 percent today from 15.8 percent in 1981.

Debt underwriters and investors say they don’t know what might happen if Treasury yields climb by more than a percentage point or two.

“I’ve been in the business for 40 years, and the reality is that we’ve never had a situation like this because this is totally manufactured by the Fed,” said Michael Holland, chairman of New York-based Holland & Co., which oversees more than $4 billion. “You have the prices of bonds acting like dot-com prices.”

The craze for so-called dot- com Internet stocks caused the Nasdaq Composite Index to more than triple between the end of 1997 and its peak in March 2000, only to plunge 77 percent by the end of September 2002. More recent- ly, the home-loan bubble more than doubled the size of the mortgage-backed bond market from the end of 2004 to mid-2007, according to Fed data, only to collapse when housing prices fell.

In both cases, banks that profited by bringing the securities to market were later accused of misrepresenting the risks and contributing to losses.

The top five junk-bond issuers last year sold more than $30 billion, as firms such as CIT Group Inc., CC Media Holdings Inc. and Sprint Nextel Corp. cashed in on the boom, according to data compiled by Bloomberg. This year’s top five already have borrowed almost $13 billion of debt through underwriters including JPMorgan and Bank of America, the data show.

CRISIS EMERGING?

Rising demand has meant more lenient terms for some debt. Borrowers are selling speculativegrade bonds that have the weakest covenants in at least two years, according to Moody’s Investors Service. Downgrades of the least- creditworthy companies outpaced upgrades last year for the first time since 2009 at both Moody’s and Standard & Poor’s.

Legal & General Group, which oversees about $3.5 billion in junk bonds globally, has shied away from about three-quarters of the high-yield deals brought to market this year amid concern that some companies borrowed too much and debts may lose their value, said Stanley Martinez, who runs high-yield credit research for a U.S. subsidiary of the London-based firm.

Legal & General has declined to buy debt sold by companies including Caesars Entertainment Corp., the biggest U.S. owner of casinos, Lennar Corp., the largest U. S. homebuilder by market value, and WEX Inc., a payments processor, he said.

“Some of the originations of high-yield loans and term bonds that you’ll see in 2013 and 2014 will be the raw material for the default cycle of 2015 and 2016,” said Martinez, who’s based in Chicago. “I’m very confident of that. But we’re not there yet.”