Money, may be extra, poured into junk bonds

Dec 04 2012, 03:08 IST
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SummaryThe money manager’s job is supposed to be straightforward: Take people’s cash and put it to work.

The money manager’s job is supposed to be straightforward: Take people’s cash and put it to work. The more money that comes in, the bigger the manager’s paycheque.

So why would two of America’s largest fund managers tell would-be investors in junk bonds, the common name for bonds issued by companies with the lowest credit ratings, to go away?

The short answer is that it’s for their own good. The market for junk bonds, the pros say, has become so popular that it’s dangerous.

Thanks largely to the unsteady economy, interest rates on US government bonds have fallen to record lows. And individual investors remain leery of the stock market.

Desperate for better returns, they’re sinking billions into higher-paying bonds backed by businesses with bad credit scores. Those deeply indebted firms have borrowed a record amount from investors and are using the money in ways that could strain their ability to pay it back.

Earlier this year, two mutual fund giants, T Rowe Price and Vanguard, began turning down people hoping to invest in funds that buy junk bonds. Both said they were running out of worthwhile places to put customer money. “It’s getting harder and harder to find places to invest,” says Michael Gitlin, director of fixed-income at T Rowe Price. He says investors are getting paid record-low interest rates for taking on much more risk.

Consider the numbers: Junk-bond sales in the US snapped the single-year record in October and have kept climbing. Sales for the year totaled $324 billion as of November 28, according to Dealogic, a data provider. In the three years leading up to the 2008 financial crisis, a time marked by easy lending, companies with junk credit ratings sold an average of $144 billion each year.

Companies are lining up to sell bonds because borrowing rates have never been lower. The typical company rated ‘speculative-grade’, one of the polite names for junk, pays 6.6% to borrow in the bond market. The average over the past decade was 9.2%, according to T Rowe Price research.

Over the past 10 years, individual investors have dropped $96 billion into the junk bond market, according to a Vanguard research paper. The bulk of it, 77%, was deposited in the past three years.

Well-known firms such as Caesars Entertainment and the parent of Century 21, Realogy, sold bonds at low rates, used the cash to pay down other expensive loans and avoided defaulting on their debts.

But what’s good

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