Wall Street junk-bond underwriters, selling debt at a record pace after the securities returned 19 percent last year, say it’s obvious that prices will drop when interest rates rise. So don’t blame the banks.
“Our job first and foremost is to properly structure deals for companies that can support their debt and perform well,” said Craig Packer, the New York-based head of Americas leveraged finance for Goldman Sachs Group Inc. (GS) “The interest-rate risk is just a law of nature.”
JPMorgan Chase & Co. (JPM), Deutsche Bank AG (DBK), Citigroup Inc. (C) and Bank of America Corp. 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. At the same time, bankers warn that demand underpinned by Federal Reserve debt purchases could evaporate, driving down prices.
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. Meanwhile, investors poured $33 billion into mutual funds and exchange- traded funds dedicated to junk bonds last year, 55 percent more than in 2011, according to Morningstar Inc.
Wall Street firms, which spent more than $93 billion dealing with costs from the 2008 credit crisis, including lawsuits and fines for allegedly misleading investors about mortgage-backed products, are once again selling debt that may be poised to lose value. This time is different, they say.
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. 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 AG (CSGN), 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 dollar-denominated 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 investors demand to own junk bonds over government 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 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 Inc. (PNC) President William Demchak, a former JPMorgan executive, said the Pittsburgh-based bank is sticking to short-term investments in its fixed-income 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 S. 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 downplayed those concerns, the people said. Michelle Smith, a Fed spokeswoman, declined to comment.
Debt underwriting, including both investment-grade 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.
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 investment-grade 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 (CCMP) 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 recently, 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. Their defense was that they were serving clients who wanted to buy the securities, as well as helping finance entrepreneurs and homeowners. They said they attracted undue criticism for essentially playing the role of middlemen and that they shouldn’t be held responsible for investors’ decisions to buy the securities.
“They’re intermediaries, and they’re not supposed to make up their minds for their customers as to what’s good for them, they’re supposed to supply them with what they want,” said Roy Smith, a finance professor at New York University’s Stern School of Business and a former Goldman Sachs partner.
Smith said bond prospectuses “point out repeatedly that just because the market price goes down, that’s not something we can be responsible for.”
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.
With Treasury rates so low, more than one-third of dollar- denominated junk bonds carried yields below 4.75 percent last month, the 10-year average rate for investment-grade bonds, according to Barclays Plc (BARC) data. Credit Suisse’s Warm said his team has been encouraging those borrowers to issue debt soon “because Treasury volatility is not their friend.”
Rising demand has meant more lenient terms for some debt. Borrowers are selling speculative-grade 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 Plc, 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.”
Bob Jacksha, chief investment officer of the New Mexico Educational Retirement Board, said he’s trying to position his fund for an increase in junk-bond defaults and interest rates. He has invested more than $600 million with Beach Point Capital Management LP, a Santa Monica, California-based hedge fund that’s betting against “the biggest, the most liquid, the most frequently traded” junk bonds, while investing in “less liquid” smaller deals, Jacksha said.
“It could build into a bubble that bursts,” Jacksha said. “Maybe it’s a bubble now.”
Some of the world’s most sophisticated investors also have sounded alarms about the prices of fixed-income investments, which peaked when the 10-year Treasury yield dropped as low as 1.39 percent in July. The 10-year yield climbed to 2.03 percent on Feb. 19 from 1.76 percent at the end of 2012.
In his annual letter to investors last February, Berkshire Hathaway Inc. CEO Warren Buffett said “bonds should come with a warning label” because such low-yielding investments probably would be eaten away by inflation. Earlier this month, Grantham Mayo Van Otterloo & Co.’s Jeremy Grantham wrote in his quarterly letter that some stocks are “brutally overpriced” and “as for fixed income — fugetaboutit.”
Oaktree Capital Group LLC Chairman Howard Marks told Bloomberg Television’s Erik Schatzker on Feb. 19 that investors are buying debt today with a 6 percent yield that they wouldn’t have bought five years ago at 10 percent. “It’s never like that forever,” he said.
Dan Fuss, whose Loomis Sayles Bond Fund beat 98 percent of its peers in the past three years, said in a Jan. 30 interview in London that the fixed-income market is “the most overbought market I have ever seen in my life in the business” and warned “interest rates are going to go up.”
The Fed’s pledge to keep short-term rates near zero “at least as long” as U.S. unemployment remains above 6.5 percent and inflation is projected to be no more than 2.5 percent is one reason why some investors aren’t worried about rates rising soon. Economists said they expect the Fed to keep rates unchanged at least through the mid-2014.
“They are telling you to take that risk, and investors are taking that risk,” Goldman Sachs’s Packer said.
It’s a risk that’s bound to backfire, he said.
“I don’t know if it will be this year, but five years from now we’re going to look back and realize that investors were taking on real interest-rate risk when they were buying any of these products and that risk came to fruition,” said Packer, whose firm ranks seventh among high-yield bond underwriters. “I feel pretty comfortable predicting that. It’s not the 2006-2007 credit risk. It’s the 2013 interest-rate risk.”
Richard Zogheb, Citigroup’s co-head of capital markets origination for the Americas, said investors are well aware of interest-rate risk.
“That’s one reason investors are exhibiting a strong preference for larger, more-liquid issues,” he said. “So they can sell if rates start to move against them.”
The Bank of America Merrill Lynch Global High-Yield Index has produced a 1.65 percent total return, which includes interest income and price gains, so far this year after a 19 percent return last year. The index is composed of 3,147 issues with a face value of $1.66 trillion.
“The notion of sort of selling everything and sitting on the sidelines is one that probably plays out every day in their minds,” said Dan Toscano, Morgan Stanley (MS)’s head of acquisition and leveraged finance. “But if you’re a long-only manager, which such a big chunk of the market is, you’re effectively shorting the market if you’re sitting in cash, and the opportunity cost of shorting can be very high.”
Junk-bond exchange-traded funds, which allow investors including retirees and hedge funds to slip in and out of the market, boosted their holdings to $30 billion in less than six years, data compiled by Bloomberg show. Those ETFs, which seek to track indexes of frequently traded bonds, are required to buy a specific subset of debt as they receive inflows.
High-yield bond funds attracted a net $2 billion in January, according to Morningstar. Managers of those funds must buy junk bonds, helping support the market.
“The smartest people — and it’s a small handful — are smart enough to close their doors and take no more money,” Holland said. “But that’s very hard to do for most managers. They continue to take the money and invest it. It makes it more extreme, as it did with the dot-coms and has done now in the yield market.”
Gary Cohn, Goldman Sachs’s president and chief operating officer, told Stephanie Ruhle this month on Bloomberg Television’s “Market Makers” program that interest rates can only go up and that he’s concerned the public may not understand how that could imperil fixed-income investments.
Cohn, 52, and other bankers and investors say they’re reluctant to guess when rates will rise.
“There’s rationality to what may on the surface appear somewhat irrational,” said Morgan Stanley’s Toscano. “I don’t think there’s a lot of conviction out there today that this market’s going to change tonight or tomorrow night.”
After all, investors who said they were staying away from the market last year missed out on some stellar returns.
“There’s an old saw on Wall Street that more money has been lost reaching for yield than at the point of a gun,” Holland said. “And here we go again.”
By Christine Harper, Donal Griffin & Lisa Abramowicz
Courtesy of Bloomberg News