Junk Debt Showing Great Depression Defaults Lures TCW By Caroline Salas and Pierre Paulden

Jan. 13 (Bloomberg) -- Record yields on high-risk, high- yield bonds and loans are luring Babson Capital Management LLC and TCW Asset Management Co., even as companies default at the fastest pace in almost five years.

Investors poured $1.7 billion into funds that buy mostly non-investment grade bonds in the last five weeks of 2008, after pulling $10.5 billion in the year up until then, according to the mutual-fund tracking service EPFR Global in Cambridge, Massachusetts. The renewed appetite for the debt follows declines that pushed the junk-bond market down 26 percent last year.

Annual yields of 18 percent may compensate for the growing risk of corporate failures as the global economy slips into its worst recession since World War II, says Jill Fields, a managing director at Babson, which oversees $2.5 billion in high-yield bonds. 2008’s slump pushed yields so far they predict corporate defaults may surpass the rate of about 16 percent reached in 1933, the height of the Great Depression.

"There’s extraordinary value at today’s prices," said Michael Zupon, who oversees Washington-based Carlyle Group’s leveraged-finance investments from New York. "The market is priced to anticipate around 20 percent annualized defaults. Even the most conservative prognosticators don’t expect that level." Zupon said he favors loans to non-investment grade companies because loans get repaid first.

Falling Prices

Prices of so-called leveraged loans tumbled 28 cents on the dollar to 66.6 cents last year, according to Standard & Poor’s LCD unit in New York. The market’s first losing performance wiped out four years of gains as the collapse of Lehman Brothers Holdings Inc. and the subsequent freeze in credit forced investors to sell.

"In high-yield and loans, it’s priced for Armageddon," said Jonathan Insull, a New York-based managing director at TCW. The Los Angeles-based firm holds $4 billion in bank loans.

At today’s prices, leveraged loans would return 5 percent even if 13 percent of companies default on their debt, according to LCD. The default rate on loans reached 4.76 percent this month, up from a record low of 0.26 percent in December 2007.

Moody’s Investors Service estimates that non-investment grade companies will fail to repay their obligations at an annual rate of more than 10 percent globally by the end of this year.

Rising Defaults

"We’re going to see defaults rise significantly, but this is largely priced in," said Todd Youngberg, a senior vice president of high-yield debt at Aviva Investors in Chicago. Youngberg said he took a bet last month that speculative-grade bonds would outperform "for the first time in a couple of years." Aviva manages $3 billion in high-yield investments.

Aviva is buying higher quality bonds and avoiding CCC rated securities because they are more likely to default, he said. Debt with a CCC ranking is four levels above default.

Babson is buying securities ranked BB and B, at the higher end of non-investment grade, and is avoiding the lowest-rated ones, Fields said. Junk bonds and leveraged loans are rated under BBB- by S&P and lower than Baa3 by Moody’s.

"14 to 16 percent is pretty good for companies I’m pretty sure are going to survive," Fields said in an interview from her office in Springfield, Massachusetts.

Apollo’s Losses

Funds at Apollo Management LP and Cerberus Capital Management LP bought loans of junk-rated companies in 2008, only to suffer losses toward the end of the year. Loan prices plummeted from 86 cents in February to 63.5 cents in December in the wake of Lehman’s bankruptcy.

Treasuries rallied 14 percent in 2008, according to data compiled by Merrill Lynch & Co.

The losses have left investors wary of crowding back into high-yield debt, said Kevin Sherlock, co-head of loan and high- yield capital markets at Deutsche Bank AG in New York.

"No one wants to be the next person to get in and call the bottom, and then have the market decline further," Sherlock said. "I’ve never had more conversations with more people who have a unanimous viewpoint that asset prices are attractive at these levels, but have no cash to transact with."

High-yield bond funds have lost 21.5 percent on average in the last year, and loan funds are down 26.3 percent, according to Morningstar Inc. data. Long government-bond funds are the best-performing category, jumping 18.9 percent.

’Ridiculously Low’

Cerberus, the $27 billion investment firm that owns Chrysler LLC, thought trading levels for debt "were ridiculously low and there was a great buying opportunity," Chief Executive Officer Stephen Feinberg wrote to investors in a letter Dec. 19. "We were wrong."

Cerberus lost 16 percent last year through Nov. 30, including 12 percent in October and November, according to the letter. Cerberus spokesman Jim Olecki declined to comment.

Apollo, the private-equity firm led by Leon Black, bought $2.2 billion of Lyondell Chemical Co. loans from Citigroup Inc. last year for 85 cents on the dollar. Lyondell filed for bankruptcy last week, and the loans have plunged to 44 cents.

Steven Anreder, a spokesman for Apollo, declined to comment.

With banks having to sell assets to reduce borrowing and investment firms needing to meet client requests for returns of cash, there will be more pressure on credit markets, Cerberus’s Feinberg said in the letter.

Narrowing Spreads

The extra yield, or spread, investors demand to own junk bonds instead of Treasuries dropped to 16.7 percentage points from a record 21.8 percentage points on Dec. 15, according to Merrill Lynch data.

The best performing securities so far this year are mortgage lender Residential Capital LLC’s 6 percent guaranteed notes due in 2011, which have climbed 30 cents to 47 cents on the dollar, according to a JPMorgan Chase & Co. report yesterday. ResCap’s parent, Detroit-based GMAC LLC, is receiving a $6 billion federal bailout to stave off bankruptcy.

As governments step in to rescue more businesses, returns on corporate bonds may "creep into double digits" this year, Deutsche Bank strategists wrote in a report this week.

TED Spreads

Investors are growing more confident as central banks lower interest rates and governments earmark trillions of dollars for stimulus plans. The three-month London interbank offered rate, a lending benchmark, has fallen 33.1 basis points to 1.09 percent since the end of last year, British Bankers’ Association data show. Libor has reached the lowest since April 2004 as central banks poured cash into money markets to encourage lending.

It costs banks on average 0.98 percentage point more than the U.S. government to borrow for three months, down from 4.64 percentage points in October. The so-called TED spread is the narrowest since before Lehman filed for bankruptcy on Sept. 15.

Junk bonds returned 6.4 percent this year through yesterday as President-elect Barack Obama sought $775 billion for his fiscal stimulus plans. At the same time, the S&P 500 Index of stocks fell 3.7 percent.

"There’s tremendous opportunities," Fields said. "Someone asked me the other day ’Do you think the bonds really rally as the economy worsens?’ I said ’Absolutely.’"

To contact the reporters on this story: Pierre Paulden in New York at ppaulden@bloomberg.net; Caroline Salas in New York at csalas1@bloomberg.net.

Last Updated: January 13, 2009 11:31 EST