Junk Bonds Feed a Hungry Market

People are looking for yield. Aivars Lode


U.S. companies with junk credit ratings are piling into the debt markets at a record pace, seizing on some of the lowest borrowing costs in history and strong demand from investors craving higher returns.

Companies and investors both have benefited. Many corporate borrowers have been able to refinance debt at much lower rates, and others have been able to raise money cheaply for investments. And so-called junk bonds, those with below-investment-grade credit ratings, have handed investors among the best returns of any fixed-income asset this year, according to Barclays PLC. Junk bonds pay higher yields because they are considered riskier investments.

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Some 130 U.S. junk-rated companies, from commercial lender CIT Group Inc.CIT +0.48% to car-rental company Hertz Global Holdings Inc., HTZ -0.07% have sold $75 billion in junk bonds this quarter, according to Thomson Reuters, up 12% from the same period last year and a record for any quarter going back to 1980 when Thomson began keeping data. "This is nirvana" for many low-rated companies, said Jim Casey, co-head of global debt capital markets at J.P. Morgan Chase & Co.

The rally in junk bonds extends an advance that began in early 2009 and can be traced largely to the Federal Reserve's policy of keeping benchmark interest rates near zero. Activity recently has picked up, bankers say, in part because some corporate finance chiefs are starting to worry that interest rates may be about to rise, despite comments by Fed Chairman Ben Bernanke that rates will remain low for some time. Bond prices move inversely to yields.

The boom in junk coincides with a return in appetite for riskier investments. In the stock market, the Dow Jones Industrial Average is up 7.6% this year and this week is on pace to be the busiest for initial public offerings since late 2007.

Bloomberg News

Investors of all stripes have been diving into junk. Many of them are searching for investments that yield more than the meager rates offered by Treasurys and investment-grade corporate bonds. They are flooding into high-yield mutual funds and exchange-traded funds, market data show.

Some analysts warn that interest rates may soon begin rising, even though the Fed aims to keep them low. That would boost the cost of borrowing. It also would drive down prices of junk bonds. Because these are bonds of some of the riskiest companies, they also would leave investors vulnerable to defaults should the economy falter.

"It's the only place I can find any yield whatsoever with a reasonable risk," said Lee Hevner, an individual investor who said he started buying junk bonds this year for the first time. In January he put about 15% of his $500,000 savings into an exchange-traded fund that holds junk bonds.

For now, though, the bonanza continues.

High-yield corporate borrowers paid an average rate of 7.98% on bonds they have sold this year, according to Thomson Reuters. That is the lowest since the junk-bond market was created in the 1980s. That compares with yields of little more than 1% on comparable Treasury notes and an average of about 3.4% on all investment-grade bonds, based on the Barclays Aggregate Bond index.

For the most part, companies are using money from the debt sales simply to refinance existing debt, or they are hoarding the cash, data show. But some market observers say that could change soon as companies start using the money for mergers or expansion. Eventually that will also help the economy, said Mr. Casey of J.P. Morgan.

"You're putting companies in better position to grow because they will be more willing to take on that debt to pursue their projects," he said.

For some companies, the interest-rate decline over the past few years has been stark. CIT, which emerged from bankruptcy protection in December 2009, two weeks ago sold $1.5 billion of bonds maturing in six years with a yield of 5.25%. That is less than the 5.8% CIT paid on similar debt in 2006, when it was rated investment grade. A CIT spokesman declined to comment.

Oklahoma City-based Continental Resources Inc., CLR +0.59% an oil producer, sold its first bond in September 2009, a 10-year note, with an 8.4% yield, following up in 2010 with two 10-year bonds yielding 7.5% and 7.125%.

But in early March, Continental sold its largest bond ever, raising $800 million at a yield of 5%. The low rate the company paid reflects its improving credit quality—the company has had credit-rating upgrades—and rapidly expanding production. But it also shows the unusual market conditions for high-yield borrowers, said John Hart, Continental's chief financial officer.

"A lot of money is flowing in, and a lot of it is coming in because it's a better investment opportunity," he said.

Ford Motor Credit Co., a unit of Ford Motor Co., F -0.04% paid 4% to borrow for three years in January, and Victoria's Secret owner Limited Brands Inc. LTD +0.28% sold a 10-year bond at 5.625% in February.

Linn Energy LLC LINE +0.10% is among companies selling bonds to pay for acquisitions. The company raised $1.8 billion in late February to fund the purchase of oil fields. "The lower cost of capital allows us to be pretty competitive," said Linn Chairman and Chief Executive Mark Ellis.

The low yields are largely due to record-low rates on Treasurys, which form the benchmark for most other interest rates.

This year, investors poured a record $18.6 billion into high-yield mutual funds and exchange-traded funds through March 26, according to Lipper Inc. That exceeded the previous record $12.8 billion set in the fourth quarter last year.

But investors run the risk of having the tide turn against them should interest rates start rising. Some analysts have begun suggesting that day could come soon.

"This is the talk of the market," said Matt Conti, who helps manage $50 billion of high-yield investments at Fidelity Investments. "My general view is it's time to be defensive."

That concern may be reflected in part in the extra yield investors demand to own junk bonds. Junk bonds yield an average 6.08 percentage points above comparable Treasurys, according to Barclays indexes. That still is well above the record low of about 2.5 percentage points reached in mid-2007.

Valuation drops, distributions stop at top REIT

where to find yield. Aivars Lode

KBS property trust share price down to $5.16 from launch price of $10; dividends to investors halted

By Bruce Kelly

March 30, 2012 3:16 pm ET

KBS REIT

Another major nontraded real estate investment trust has seen a sharp drop in its value — but is also stopping paying distributions to investors.

KBS Real Estate Investment Trust Inc., or KBS REIT I, told investors Monday it was cutting the value of the REIT to $5.16 per share, from $7.32, a drop of 29%. The REIT's offering price was $10 per share.

A number of REITs have seen valuations decline this year as the commercial real estate market continues to struggle and debt weighs on REITs' balance sheets.

“The new pricing of KBS REIT I reflects the current status of the portfolio, and the discontinuation of distributions was made with the goal of managing the REIT's debt obligations and cash flows, and attempting to maximize the total return to investors over time,” said Keith Hall, executive vice president of KBS REIT I.

The REIT is substantial, having raised $1.7 billion in equity in its initial offering, according to an investor presentation the company filed with the Securities and Exchange Commission on Monday. It has $3.4 billion in property assets, and holds loans and other debt of $2.3 billion.

Distributions to investors will be cut to zero, it announced. The REIT “will discontinue paying monthly distributions to shareholders in an effort to maximize the total amount of capital returned to shareholders over time,” according to the filing.

Since July 2009, annual distributions had been 53 cents per share, according to the filing.

The company said cash flow will be used to meet four objectives: paying down debt, strategically reinvesting capital, attempting to improve the overall return of the company and managing the REIT's reduced cash flow.

When asked to clarify what the last objective meant, Mr. Hall noted that it was simply one of the stated company objectives.

The KBS REIT has been hit by the broad decline in the commercial real estate market since 2008. Occupancy of the REIT's real estate holdings declined last year to 85%, from 92% in 2010, according to the filing.

Added to that, rents are in decline. “REIT I's existing rents are rolling downward into this moderately improving rental market that still remains well below peak levels,” according to the filing.

Eighty-one percent of the REIT's portfolio is in office space, with 10% in bank branches and 9% in industrial real estate.

KBS REIT I “has not been immune” to the broad real estate market's difficulties,” Mr. Hall said. “While some markets have recently made slight recoveries, many markets are still challenged with decreasing occupancy and/or new lease rates at substantially lower levels from the 2007-08 peaks.”

Another nontraded REIT sees value plummet

 If you do not understand where in the cycle you are investing this may be the result. Aivars Lode

Pacific Cornerstone property trust hammered; 'only option is to liquidate,' claims due-diligence expert

By Bruce Kelly

March 28, 2012 3:48 pm ET

REIT

Another nontraded real estate investment trust has taken a sudden and precipitous decline in value — this time plunging nearly 72%.

Investors in the Cornerstone Core Properties REIT Inc. were told this month by the company that the shares, once valued at $8, are now worth $2.25. “The estimated per-share value has been adversely affected by the recent global economic downturn, negatively impacting our small business tenant base, which has resulted in approximately $43 million of previously announced impairment charges recorded in the second and third quarters of 2011,” according to the letter, which was signed by Terry Roussel, the REIT's chairman and chief executive.

A sharp decline in tenant occupancy has hammered the REIT: Tenant occupancy of the REIT's retail properties was 69% at the end of last year, compared with 92% at the end of 2008.

“A couple of years ago, the sponsor had some regulatory issues and had to shut down capital raising,” said Anthony Chereso, CEO of FactRight LLC, a due-diligence firm that covers managers of alternative investments. “It had some properties with tenant issues, and the portfolio had issues with covering debt and distributions. It was not constructed well.”

Mr. Roussel did not return calls seeking comment.

FactRight last year recommended that broker-dealers pull the Cornerstone Core Properties REIT from their platforms, Mr. Chereso said.

The REIT's regulatory issues had to do with marketing at the sponsor level, Mr. Chereso said. The sponsor broker-dealer is Pacific Cornerstone Capital Inc. “Their only option is to liquidate,” he said. “There's not a whole lot that can be done to revive it.”

The Cornerstone REIT raised only $172.7 million between 2006 and 2009, making it a relatively small player in a marketplace in which the largest players have raised and deployed billions of dollars. Still, other nontraded REITs or real estate funds sold by REIT sponsors recently have seen dramatic declines in value, eating away at investors' portfolios and making life difficult for the brokers who sold the products.

At the end of December, investors in the Behringer Harvard Short-Term Opportunity Fund I LP, which had about $130 million in total assets, saw its valuation drop to 40 cents a share, down drastically from $6.48 a share Dec. 31, 2010.

And the Behringer Harvard Opportunity REIT I Inc. saw its estimated value decline to $4.12 a share at the end of last year, from $7.66 a year earlier.

The Cornerstone Core Properties REIT changed its chief financial officer at the end of last year, replacing Sharon Kaiser with Stephen Robie, according to filings with the Securities and Exchange Commission.

The REIT has been focused on paying down debt, selling three properties in the fourth quarter of 2011 with $24.8 million in sales value. The proceeds were used to pay down $13.5 million of debt and to build cash reserves, according to an SEC filing.

The Private Equity/ Sustainability Link

Private equity trying to redefine itself vs having an open and transparent business model to begin with! Aivars Lode


Private equity often gets a bad rap these days. But David M. Rubenstein, a co-founder and managing director of Carlyle Group, argues that private equity can help companies become more sustainable and socially responsible. And that, in turn, can help companies make even more money.Mr. Rubenstein discussed Carlyle's efforts with Jennifer S. Forsyth, the Journal's national editor. Here are edited excerpts of their discussion:

The private-equity giant recently teamed up with the Environmental Defense Fund and a consultant, Payne Firm, to incorporate environmental considerations in its due-diligence process. It's part of the firm's efforts to consider environmental, social and corporate-governance (ESG) principles in the way it invests.

MS. FORSYTH: Private equity has been in the news quite a bit. There have been accusations that private-equity firms, in striving for greater efficiency, squeeze companies to the point that they might imperil them down the line. One stated goal of the Carlyle Group is to invest with social responsibility, to be ethical in your investing. So explain to us how a private-equity firm can be socially responsible at the same time.

Genesis Photos for The Wall Street Journal

DAVID M. RUBENSTEIN: 'Sustainability equals more cash flow.'

MR. RUBENSTEIN: Well, the implication of the question is that a private-equity firm couldn't be socially responsible. And that reflects the image that we probably have. Private equity is an industry that grew up in the U.S. over the past 40 years or so. And the reason it's grown is because private-equity firms have been able to earn for their investors, most of whom are large public pension funds, rates of return that are higher than anything else that they can get with their money.

Historically, when I went out to raise money I would say to investors, "Here's our rate of return, and here's why it's very high," and they would give me money. In recent years I've noticed that investors aren't interested only in rates of return. We understand that investors are interested in things that are more socially responsible. So we adopted ESG principles, and we became the first private-equity firm to establish a set of guidelines under which we will operate and analyze our companies.

MS. FORSYTH: But do you make as much money?

MR. RUBENSTEIN: There's no way to really know for sure. We try to operate under the principle that, if we do things that improve sustainability, in the end that's a good thing for humanity. It's a good thing for our investors. It's a good thing for the company. And in the end profits will be realized.

Einstein famously said, "e equals MC squared." In my view what we should say is "S equals MC squared." Sustainability equals more cash flow. And if you are willing to put in the time to improve the sustainability principles of a company, you can in fact make more money.

MS. FORSYTH: One of the things smaller, closely held companies sometimes deal with is that they want to make their operations more energy-efficient, for example, but it may require a capital investment. And either they don't have the cash on hand or they don't have the debt available to do that. It's my understanding private equity doesn't have that problem, and you can make those kinds of investments. Can you give an example of a company you bought where that really played out?

MR. RUBENSTEIN:In the U.S. we teamed up with the Environmental Defense Fund and developed something called EcoValuScreen. When we look at buying a company we can say, "Here is where there are energy and environmental liabilities, but here's also where there's energy and environmental opportunities."

In the old days when we would buy a company we would say, "What are the risks we're going to take in the environment? What are the risks we're going to take in the energy area?" Now we say, "How can we improve these areas and how can we actually make money doing this?" Now if we take a look at a company and say it will take us 10 years or 15 years to improve the environmental sustainability of the company, we're probably not going to make an investment that will take 15 years to be paid back.

MS. FORSYTH: Because you don't typically hold it that long?

MR. RUBENSTEIN: Private-equity firms typically hold things for four to six years, because often our investors want to recycle and get profits back in that period of time.

But if we can look at something and say, "If we made some improvements in the environmental area or the sustainability area, and if we could make our money back in two or three years," then of course we would do that.

Retirement planning's tough choices

Yield is hard to find unless you have investments that are led by professionals that are experts in a field. The investments are clearly identifiable and based upon free cash flow not growth. Aivars Lode

Retirees unwilling to trade risk for yield are cutting back their lifestyle

By Lavonne Kuykendall

March 25, 2012 6:01 am ET

Michael and Nancy Hoaglund saved diligently for many years to fund a secure retirement, but it took just one miscalculation to scuttle their plans.

“I am the kind of person who wears a belt and suspenders,” Mr. Hoaglund said of his aversion to risky investments. “We never got into any dot-com stocks in the 1990s or any other get-rich-quick schemes.”

Whenever his broker called him with hot stock tips, Mr. Hoaglund firmly told him that he wanted only conservative investments.

When they were working, the Bloomington, Minn., couple saved regularly for their retirement. Mr. Hoaglund, now 75, retired in 1997 when he sold his small manufacturing business. A year later, Mrs. Hoaglund, now 74, retired from her job as an administrative assistant at a local church.

The couple did many things right but made one mistake that has haunted them, Mr. Hoaglund said. They used their broker's too-optimistic estimate that they could count on annual market returns of between 6% and 8%, and they overspent in the crucial early years of their retirement.

When the stock market declined in the aftermath of the dot-com bubble and 9/11 terrorist attacks, so did the value of the Hoaglunds' retirement account. That, combined with tepid market returns and low interest rates over much of the last decade, has forced the couple to scale back their lifestyle and left them with a retirement far more frugal than they ever planned for.

The Hoaglunds are not alone. Whether it is the result of poor planning, bad advice or plunging markets, many retirees are licking their financial wounds. The current low-interest-rate environment doesn't help, especially for conservative investors such as the Hoaglunds, who are unable or unwilling to sacrifice safety for yield.

“Retired investors want riskless returns, and that is a tall order,” said Brian Ullmann, a wealth manager with Ford Financial Group. In recent years, he has spent time educating many clients about the trade-off between risk and return, he said.

“One client told me, "I'm not risk-averse; I just hate losing money,'” Mr. Ullman said, noting that it's an attitude that sums up the way many retirees feel about their investments. “It is a scary environment for retirees right now.”

Most retirees have adjusted by reducing the amount of money they take out of their accounts, although once they pare back their budgets as much as they can, some accept the idea of taking on more risk. “Others lose too much sleep, and it is not worth their sanity to increase their risk,” Mr. Ullmann said.

Today, the Hoaglunds take their reduced lifestyle with cheerful good humor. Married for 50 years, they said they consider themselves fortunate because they have good health, and don't mind that a rare evening out typically consists of a hot dog dinner at the local Costco.

When Mr. Hoaglund had knee replacement surgery a few winters ago, Mrs. Hoaglund carefully shoveled the walk so he wouldn't slip, and said she was just a little wistful when she thought of how much nicer it would have been for him to recover at the second home in Florida they were forced to sell in 2004. They can afford only one car instead of the two they had before, which makes both feel a little less independent.

“You need to be much more hands-on with your retirement planning,” Mr. Hoaglund said. “You need oversight, and I didn't do it the way I should have.”

BLAMES BROKER

Although Mr. Hoaglund was diligent about preparing cash flow statements for his business, his broker never did that for his retirement plan, an omission that he believes led them astray. Eventually, he took over managing his investments and in 2008 met with a retirement specialist to develop a comprehensive plan.

“The Hoaglunds were wise enough to re-evaluate how to manage their assets,” said Joseph S. Lucey, president of Secured Retirement Advisors LLC, who worked with the couple. “They had to make some tough choices, but we were able to find them what they most needed — an income stream they will never outlive.”

The Hoaglunds used some of their savings to buy enough annuity income to cover their basic ex-penses, and invested the rest in a conservative portfolio for supplemental income.

“When we look at annuities, we plan based on the guaranteed return, not the hypothetical or average return,” said Mr. Lucey, adding that retirees crave that kind of certainty.

For retiree investment portfolios, Mr. Lucey focuses on yield, using REITs selectively, along with dividend-paying stock funds and separately managed accounts.

ANNUITIES POPULAR

Annuities have become far more popular in recent years, partly because low interest rates have made it difficult for retirees to wring much income out of laddering CDs or bonds, said Shannon Reid, director of retirement solutions at Raymond James Financial Inc.

So-called aristocrat dividend stocks also are popular now, she said. Aristocrats are blue chips, such as Verizon Communications Inc. (VZ), Lowe's Cos. (LOW) and Stanley Black & Decker Inc. (SWK), that consistently increased their dividends over the past five years.

“You have to be in the market, because you need growth and in-come,” Ms. Reid said. “Advisers and investors are much more open to product allocations that include annuities and are more inclined to stay in fixed income and equity markets.”

The search for safe yield leads some advisers to recommend ultradiversification into products that can provide better returns than the ultra-safe Treasury bonds many retirees favor.

“It really is a matter of what they are comfortable with,” said Jim Sloan, president of Jim Sloan & Associates. He tells his retired clients that he might be able to generate more income by taking on a little more risk, “but there is no guarantee,” he said. “It is called "maybe' income.”

Wealthier clients with several million dollars are more likely to go that route, he said.

The Hoaglunds went the more conservative route. They contend that having ironclad income security outweighs the lure of taking on risk to gain a little more yield, especially for a belt-and-suspenders couple.

“I thought we would be able to play more,” Mr. Hoaglund said. “We thought we would be able to travel, but sometimes your blessings are different than what you expected.”

Global Investing: Considerations for Building an End-to-End Solution

As the capital markets continue to expand beyond the U.S., brokerage firms and their clients are seeking greater global access and the ability to trade international instruments directly. However, developing a global investing solution calls for an investment of capital, talent and time. Even large, successful organizations often lack the expertise, local market knowledge, tools and people they need to go to market.

Quitting while they’re behind

THE past few years have been “as miserable as I can remember”, says Johnny Boyer of Boyer Allen Investment Management, a British hedge fund focused on Asia. The fund, which looked after $1.9 billion at its peak, faced the prospect of spending the next few years trying to claw its way back to pre-crisis asset levels. Instead the founders decided to shut the fund and give investors their money back.

Others have also had enough. “I’ve been doing this for 15 years and I’ve never seen as many people give up as in the last three months,” says Luke Ellis of Man Group, a large listed fund. This trend is distinct from the round of closures in 2008. Then, managers were hit by investors’ redemptions and had no choice but to close; today many are electing to walk away.

For some managers, the markets have become too stressful. Running a hedge fund today is “three times as much work for a third of the fun,” says one. But many are motivated by economics. Hedge funds typically get paid a 2% management fee on assets to cover expenses and a 20% performance fee on the returns they achieve for investors. Most funds do not earn performance fees unless they outperform their peak level or “high-water mark”. At the end of 2011, 67% of hedge funds were below their high-water marks, according to Credit Suisse, and 13% have not earned a performance fee since 2007 or earlier.

Funds can survive off a management fee for a couple of years, but four is a long time to go hungry. Most managers were banking on a recovery in 2011 but the average hedge fund slid by 5.2%—much worse than the S&P 500, which returned 2%. Poor performance is causing changes in the way the industry markets itself (see article). It also means many funds will have to wait even longer to earn a performance fee again. According to Morgan Stanley, 18% of hedge funds are more than 20% below their high-water marks.

Smaller funds have been more likely to close than their larger peers. That’s partly because it used to be possible to run a hedge fund with $75m under management. Today funds need at least double that amount because administrative and compliance costs are higher than ever. Larger funds also depend less on performance fees because their management fees bring in so much cash. John Paulson, a hedge-fund giant whose flagship fund was clobbered last year, has pledged to make up investors’ losses but his fund is so large that he can easily afford to carry on. That risks distorting the original point of hedge funds—that they are small, limber operations which come and go often (see chart).

For investors, it is generally a good thing if underperforming managers are returning cash and not milking them for fees. But others worry that high-water marks could skew funds’ investing decisions. Managers who have not earned a performance fee in years could take bolder bets to get back into the black. Leverage levels have been creeping up. Some may prefer to go out with a bang, not a whimper.