‘Unloved’ Junk Debt May Be Best Bond Investment: Credit Markets

April 6 (Bloomberg) -- Speculative-grade bonds with the highest rankings may offer the best returns after trailing the riskiest debt in a record credit-market rally.

Goldman Sachs Group Inc. is recommending high-yield, high- risk bonds with rankings in the BB tier, the first below investment grade on the Standard & Poor’s scale. Pioneer Investment Management Inc. favors BB and B bonds, the next lowest bracket, while saying the riskiest debt is overvalued. Debt ranked in the BB category gained 39.1 percent in the past 12 months, underperforming the CCC tier by 66 percentage points, according to Bank of America Merrill Lynch index data.

Junk bonds have rallied at an unprecedented pace since December 2008 after the market seizure that followed the failure of Lehman Brothers Holdings Inc. Companies are issuing record amounts of the debt as the economy improves, corporate default rates decline and the Federal Reserve holds interest rates at near zero, spurring investors to seek higher yields.

“BBs have been in an unloved space, too risky for investment-grade investors but not risky enough for high-yield investors,” said Alberto Gallo, a strategist at Goldman Sachs in New York. “That has preserved a lot of value.”

Investors seeking higher returns amid low rates will drive up prices on BB debt, which also offers some protection from defaults if the economic recovery flags, Gallo said.

Gains in speculative-grade debt are justified by lower default rates, said Andrew Feltus, a money manager who helps oversee $8 billion of high-yield debt at Pioneer in Boston. His $2.8 billion Pioneer High Yield Fund has returned 62 percent in the past year, in the top 5 percent of funds, according to data compiled by Bloomberg.

‘CCCs Look Rich’

“CCCs look rich to me,” Feltus said. “We’re not in love with leveraged buyouts, and the default rates will be higher for these securities.”

High-yield, high-risk, or junk, debt is rated below Baa3 by Moody’s Investors Service and lower than BBB- by S&P.

Elsewhere in credit markets, the extra yield investors demand to own corporate bonds rather than government debt fell yesterday to 148 basis points, or 1.48 percentage point, the lowest since November 2007, the Bank of America Merrill Lynch Global Broad Market Corporate Index shows. The average yield rose to 4.075 percent, the highest since Feb. 24.

Leveraged Loans

Leveraged loan prices climbed 0.07 cent to 91.91 cents on the dollar, the highest since June 2008, according to the S&P/LSTA U.S. Leveraged Loan 100 index. Supervalu Inc., the second-largest U.S. grocery chain, extended the maturity of $2 billion of bank loans to 2015, according to a person familiar with the transaction. The Eden Prairie, Minnesota-based retailer also extended $500 million of its $1 billion term loan to October 2015 from June 2012, the person said.

Fannie Mae’s current-coupon 30-year fixed-rate mortgage bonds fell 0.02 percentage point to 4.65 percent, holding near the highest level since Aug. 10, Bloomberg data show. The Fed ended its unprecedented purchases of the debt last week.

An indicator of U.S. corporate credit risk rose from a more than two-week low today.

The Markit CDX North America Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses on corporate debt or to speculate on creditworthiness, rose 1.2 basis point to a mid-price of 84.6 basis points as of 1 p.m. in New York, according to Markit Group Ltd. The index typically rises as investor confidence deteriorates and falls as it improves.

In London, the Markit iTraxx Europe Index on 125 investment-grade companies fell 0.69 basis point to 76.6 basis points, Markit prices show.

Junk Bond Offerings

Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Nexstar Broadcasting Group Inc. of Irving, Texas, and Fort Myers, Florida-based Radiation Therapy Services Inc. led five companies that began marketing at least $1.34 billion of high- yield bonds yesterday.

Companies in the U.S. have issued $70.125 billion of junk bonds in 2010 as corporations with speculative-grade rankings sought to take advantage of the lowest borrowing costs since October 2007. That compares with $12.8 billion for the same period in 2009, Bloomberg data show.

The Bank of America Merrill Lynch U.S. High Yield Master II index gained 4.99 percent this year, following a 57.5 percent return in 2009. Debt graded in the CCC tier and below has more than doubled in the past year.

Tightening Spreads

Spreads on BB ranked debt have fallen 0.66 percentage point to 4.07 percentage points since the start of the year, the Bank of America Merrill Lynch index shows. That’s down from the record spread of 14.68 percentage points in December 2008 and above the long-term average of 3.84 percentage points.

For debt ranked CCC and lower, relative yields have declined 0.81 percentage point this year to 9.19 percentage points, index data show. That compares to the record 44.3 percent spread over benchmarks in December 2008 and is below the long-term average of 12.56 percentage points, index data show. BB rated bonds have returned 4.9 percent this year, while bonds rated B and CCC have returned 3.8 percent and 7.1 percent, respectively.

The bonds of companies with the highest junk ratings are poised to thrive in an economy that may slow as the Fed begins withdrawing a record $1 trillion in excess cash that propped up the banking system during the recession.

‘Sweet Spot’

“BBs in particular are the sweet spot for a slow recovery environment,” said Goldman Sachs strategist Gallo, who said investors in the bonds will benefit as the Fed keeps interest rates low to guard against another slump, while foreign investors seek higher yielding assets that offer a cushion against another slowdown.

Goldman Sachs, based in New York, estimates that the economy will grow at 2.6 percent in 2010, below the 3 percent median forecast, Bloomberg data show.

While Moody’s said the speculative-grade default rate will decline to 2.9 percent by the end of the year from a record 12.9 percent in November, companies with the lowest rankings will need a strong recovery to reduce debt and avoid default, Gallo said.

Fed officials said they planned to keep the main overnight interest rate near zero for an “extended period” after meeting on March 16.