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Money _ maybe too much _ pours into junk bonds

Published on NewsOK Modified: December 2, 2012 at 12:36 pm •  Published: December 2, 2012

Gitlin and others say recent trends remind them of the easy-lending era before the financial crisis, when Wall Street and bond traders treated caution as a sign of weakness.

"When you start seeing things like you saw in '06 and '07, you should be concerned," Gitlin says.

Over recent months, more than a third of the money raised in the market has gone to corporate borrowers that credit rating agencies consider likely candidates for bankruptcy, those with the lowest of the low credit scores, according to S&P.

Where the money winds up has changed, too. Some of it simply fuels deal-making by private equity firms, investment groups like Bain Capital and The Carlyle Group that buy and sell businesses. In these leveraged buyouts, a private equity firm borrows money to buy a company, then saddles it with the debt.

More of these private-equity firms find they can dip into the bond market to reward themselves. In these "dividend deals," a company sells bonds and gives the proceeds to the owners, even though the company has to cover the debt.

In one recent deal flagged by the rating agency Moody's Investors Service, the management consulting firm Booz Allen Hamilton raised $1 billion to pay a dividend to The Carlyle Group and other firms.

"Private equity firms are basically saying, 'Hey, if you want to give us your money at record low rates, we'll take it," says Kingman Penniman, founder of KDP Investment Advisors.

Yet another alarming trend is the reappearance of bonds that allow corporate borrowers to switch off their interest payments. They're known as "PIK toggles," because the issuers can toggle off their regular payments and "pay in kind" with IOUs. Investors who bought them during the mid-2000s credit bubble got burned.

"You'd think, 'We'll never let issuers get away with that again. PIK toggles are dead,'" Gitlin says. But fund managers have to put investors' money somewhere, Gitlin says, so they wind up holding their noses and buying against their better judgment.

What bothers Chris Philips, a senior analyst in Vanguard's investment strategy group, is that so many people have trusted their savings to bond funds because they're not considered as dangerous as stocks: Buy a bond, and as long as the country, state or company behind it stays in business, you can expect to get your money back.

It's a different story for people who invest in a bond mutual fund. The fund's price rises and falls to reflect the total market value of the scores of bonds within it.

Junk bonds backed by companies with the worst credit can be just as risky as stocks, Philips says. Unlike other types of fixed-income investments, the junk market is prone to big price swings when traders get nervous. At the depths of the 2008 financial crisis, an overall market index sank from around 90 cents on the dollar to 55 cents.

"That's a big hit," Philips says. "I think the average person's association with bonds is that they should be safer than stocks."

All it will take, Phillips and others say, is a dust-up in Washington over avoiding the tax hikes and government spending cuts known as the "fiscal cliff" to cause a sharp drop in the stock market. If that happens, the junk-bond market will likely take a fall.

And then, Gitlin says, a lot of new bond investors will be calling up their fund managers to ask: "How can you lose money in a bond fund?"