Friday, June 10, 2011

As 'Junk' Bonds Fall, Some Blame the Fed

As 'Junk' Bonds Fall, Some Blame the Fed


A steep decline in prices of bonds backed by subprime mortgages has spread through the riskiest segments of the credit markets, ending rallies in high-yield corporate bonds and commercial real-estate debt.

Weak economic data including falling home prices and disappointing jobs numbers have led investors to dump these securities, which had risen strongly since the financial crisis.

.The decline in high-yield, or "junk," corporate bonds accelerated after last week's employment figures, with prices falling nearly 1% on Thursday, the worst one-day loss in three months. Junk bonds offer high yields due to high default risks.

The market for subprime bonds started falling in early April, around the time the Federal Reserve Bank of New York launched an effort to sell pieces of a multibillion-dollar portfolio of subprime bonds it has been holding since late 2008.

Since April, prices of many subprime mortgage securities have declined between 15% and 20%, sparking concerns from traders and investors that the Fed's sales are pressuring a weakening market.

On Thursday, the New York Fed sold only half of a $3.8 billion batch of bonds it sought to auction off this week.

Some of the selloff can be attributed to a heavy supply of these bonds, both from the Fed and from companies taking advantage of better market conditions since the crisis. Companies issued a record $114 billion worth of junk bonds through June 2, a 27% increase of the same period last year, according to Standard & Poor's Leveraged Commentary & Data.

"The timing couldn't be worse for the market," said Marina Tukhin, head of asset-backed securities trading at Gleacher Descap in New York, referring to the effect of the Fed's auctions on the mortgage market, which she calls "oversaturated" with troubled assets.

Investors have scaled back their appetites for risky investments in recent weeks amid renewed concerns about the European debt crisis and data indicating a U.S. housing recovery is still ways off.

The decline in subprime mortgage bonds accelerated in the last two weeks with prices of some bonds falling roughly nine to 10 cents on the dollar from their April highs. Soon after these bonds started falling, an index known as the CMBX, which tracks commercial mortgage debt, also headed down and has declined substantially.

The New York Fed has so far sold off roughly $10 billion of bonds it inherited from the bailout of American International Group Inc., about a third of a portfolio known as Maiden Lane II, at discounts to the bonds' face value. The regional Fed bank held weekly auctions for pieces of the portfolio in April, but recently decided to slow down the pace of sales after getting market feedback. Thursday's auction was the first in three weeks, and the next one will be after the July 4 holiday.

Wall Street traders groused that the Fed's sales have been a big reason for the latest downdraft in prices of risky U.S. debt. An index known as the ABX, a proxy for prices of subprime bonds, recently traded at about 47 cents on the dollar, a level last seen in March 2010, according to data from Markit. It is still well above its crisis low of about 29 cents on the dollar.

Analysts say the price declines have created a negative feedback loop in the credit markets, with weakness spilling over to derivatives on commercial mortgage backed securities and now junk bonds.

Traders said investors are buying credit protection in the derivatives market to hedge their investments, and this occurs more as prices continue to fall. As the cost of protection against defaults rises, so do yields on many bonds. Bond prices and yields move in opposite directions.

Other investors said the selloff in mortgage bonds prompted hedge funds that invest in risky debt to sell their junk-bond holdings but pick up relative bargains among subprime bonds.

When the Fed began the sales, it reasoned that the mortgage-debt market had stabilized and conditions were "right" for Maiden Lane II to begin "more extensive sales while taking appropriate care at all times to avoid market disruption." From the Fed's perspective, the sales have gone relatively well so far and the bank has been able to be a selective seller, accepting only bids that it likes. It has so far sold about 75% of the $13.4 billion in bonds it put for sale over the last two months.

In the junk-bond market, investors worried about the slowing economy have cooled their love affair with these securities.

Softening demand also tightened borrowing conditions for junk-rated companies. Forestar (USA) Real Estate Group Inc. pulled a $250 million deal today citing adverse conditions that prevented it from obtaining the terms it expected. Clear Channel Communications, a radio broadcaster with a relatively low credit rating of triple-C+ from Standard & Poor's, was forced to sell a $750 million bond offering at a significant discount to its existing debt in order to get the transaction done.

"Investors are repositioning to reduce risk across their books as GDP expectations are lowered," said Jim Keenan, head of leveraged finance in BlackRock Inc.'s portfolio management group. "Not only did we have weaker data than expected, but the next couple months will be a period of uncertainty drawn around policy, from what Europe is going to do about Greece to what the U.S. government is going to do about the budget deficit."

Despite the sell-off, the junk bond market has still outperformed other markets this year. Year-to-date, the total return of the JP Morgan Domestic High Yield Index is 5.7%, compared to 4.72% for the Dow Jones Industrial Average and 2.49% for the S&P 500.

—Al Yoon contributed to this article.
Write to Serena Ng at and Matt Wirz at

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