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Junk Bonds Grow More Popular and Turn Even Riskier

Junk bonds are living up to their name again.

Fotopic | Photolibrary | Getty Images

Petco sold $550 million in five-year notes to pay dividends to its private equity owners.

Companies with junk credit ratings have been increasingly issuing bonds for riskier purposes that could hinder their ability to pay back bondholders.

Demand for junk bonds has touched record levels this year as investors reach for their rich yields, a stark contrast to the meager returns available on Treasury securities and money market accounts. But the voracious demand has allowed companies to easily raise money for things that may actually end up weakening them.

For most of this year, the bond issuers were at the higher end of the junk credit-rating spectrum, and were using the money to refinance old debt at lower interest rates, thereby solidifying their economic footing. That made many analysts feel more comfortable about the flood of new junk bonds.

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But in recent weeks, there has been a decline in the average credit rating of the companies issuing junk bonds, to C ratings nearer the bottom of the junk rankings from the BB ratings at the top. And companies have been using more of the proceeds for the sorts of risky projects that were common before the financial crisis and in the go-go days of the 1980s — paying dividends to private equity owners and financing mergers and leveraged buyouts.

Jo-Ann Stores and Petco, for instance, both with junk ratings of CCC, sold a combined $875 million of bonds this month, with some of the money set to quickly leave the companies through dividend payments to their private equity owners. Many analysts say that the practice can hurt the financial health of the companies by increasing their regular interest payments to bondholders without strengthening the underlying business.

"Companies that were having difficulty coming to the market, or who want to be more aggressive, have now gotten the opportunity to do so," said Kingman Penniman, the founder of a junk bond research firm. "Clearly it's a disturbing trend."

The shift is particularly worrying to Mr. Penniman and others because so much of the money going into these bonds is coming from individual investors who may be unaware of the declining credit quality.

Over the first three quarters of the year, retail and institutional investors piled into junk bonds with equal alacrity. The record for junk bonds issued in the United States in a single year was broken on Oct. 18, and now stands at $293 billion, compared with $249 billion in all of 2011, according to Dealogic. But in recent weeks, as the bonds have grown riskier, figures from the data company EPFR show that wiser institutional investors have begun to shift money out of junk bonds, as individual investors have continued to pour in. Retail investors added about $2.1 billion to their portfolios in the first three weeks of October, compared with a net outflow of $256 million from institutional investors.

The flows into junk bond mutual funds are pushing the managers of these funds to buy up whatever junk bonds are being issued — even if they worry that the bonds could eventually run into trouble.

"The inflows are forcing people to look at these things, even though they might want to hold their nose," said Mark Hudoff, a portfolio manager at Hotchkis & Wiley, a mutual fund management company.

The most commonly cited reason for the recent surge of risky new bonds is the monetary stimulus program announced by the Federal Reserve in early September. By buying up safer mortgage-backed bonds, the Fed is trying to push investors to take on more risk. This would generally lead to big purchases of stock, but after the financial crisis, stocks still carry a stigma for many investors.

(Read More: Here's the Secret to Making Money in Stocks This Year )

Because bonds, whether investment-grade or junk, do not lose all their value when a company goes bankrupt, they carry a greater aura of safety than a company's stock, which can be wiped out in a Chapter 11 filing. This year, retail investors have put about $22 billion into junk bond funds, compared with the $8.3 billion that went into these funds in 2011 from all sources, according to EPFR.

Because of the minuscule interest rates being offered on other types of bonds, some analysts say junk bonds still represent a good deal. Even as the interest rates on junk bonds have fallen to their lowest levels ever, the yields on Treasury bonds have fallen even more quickly. The total return on high-yield bonds this year has been 12.8 percent, compared with 9.6 percent on investment-grade bonds and 14.1 percent on the Standard & Poor's 500-stock index, according to the Royal Bank of Scotland.

But Carl P. Kaufman, who buys bonds for Osterweis Capital Management, said he is having to be much more selective in which junk bonds he buys, to avoid those that "are going for no productive purpose."

Among the bonds that worry investors are those being used to pay for acquisitions, a riskier pursuit than the refinancing that dominated earlier this year. Some private equity companies are raising money for new leveraged buyouts, which can load the acquired company with debt. David's Bridal, for example, borrowed $270 million, rated CCC by Standard & Poor's, in early October to finance its sale from one private equity owner to another. The company declined to comment.

Then there are the bonds issued to pay dividends to a company's private equity owners. The hospital company HCA borrowed $2.5 billion on Oct. 16, in part to make payments to its three private equity owners — Kohlberg Kravis Roberts, Bain Capital and Merrill Lynch Global Private Equity. Mr. Penniman said that deals like this, in isolation, increase a company's debt and make it harder to fulfill its obligations to bondholders.

A spokesman for HCA, Ed Fishbough, said: "We're pleased with the response to our offering" from investors, and also with the company's debt levels.

The trend that worries investors most is the rise of bonds that allow the borrower to skip cash interest payments if it hits financial trouble, removing one of the most attractive features of bonds: the guaranteed fixed income.

"It is an expression by the company that we're not sure we're going to be making enough money to pay the interest for the next few years," said Adam B. Cohen, the founder of Covenant Review, a credit research firm.

There have been more of these bonds issued over the last month than there were over the first eight months of the year, according to data from the Royal Bank of Scotland.

Jo-Ann Stores and Petco incorporated that optional interest payment feature into the notes they issued to make dividend payments to their owners. Petco borrowed $550 million for five years at 8.5 percent; Jo-Ann Stores issued $325 million of notes at 9.75 percent for seven years. The private equity owners declined to comment.

Mr. Cohen said that the demand for high-yield bonds is keeping the lawyers who work on the projects busy and giving them freedom to take more and more liberties with the terms of borrowing. He says that these lawyers have told him, "We're just writing up the contracts however we want, because people are buying everything."

Mr. Kaufman said that the companies issuing these bonds were not likely to hit problems immediately, but at some point the riskier behavior was likely to catch up with them, and their investors.

"All the sudden you will have that surprised look on your face when it hits the fan," Mr. Kaufman said.

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