So much for that de-leveraging

September 25, 2009

You would think it would take a little longer for hedge funds and other investors addicted to using borrowed funds to juice returns before they started loading up on high-yielding junk. But with short-term borrowing costs so low, I suppose it was just too hard to resist yields found in the depths of high-yield bond market.

CCC-rated bonds, the darlings of the current rally in corporate debt, have broken though another milestone , according to Martin Fridson of Fridson Investment Advisors. Its spread over Treasurys as measured by Merrill Lynch, fell to 12.18 percentage points this week, below it’s historical average. Meanwhile, higher-rated junk spreads are still much higher than their averages.

Fridson notes that leveraged investors have been fueling demand for the junk bond market’s junkiest debt.

Not all of them, but some, have a simple strategy:  Maximize the differential between the interest rate on borrowed money and the yield on assets in the portfolio.   If the investment strategy does not take into account the adequacy of the yield on those assets, relative to their credit risk, who is to say what constitutes an excessively tight spread?  As long as the yield exceeds the cost of funds, the trade is a money-maker…until the defaults begin.  To get the maximum “benefit” from this strategy, leveraged investors gravitate to the highest-yielding segment, the Triple-Cs.

Just as long as they don’t need to get bailed out…


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