Junk bonds: yields falling as investors chase returns.

Overview: Junk bonds, high-yield bonds, distressed debt--the market for speculative corporate debt has always spooked the average investor, as it should. Meanwhile, a slew of savvy hedge fund managers have plunged into the market chasing higher returns.

After bottoming out in 2002, the high-yield market roared back to life this year. Though prices have skyrocketed, driving yields down, investors who got into the junk market early this year have been richly rewarded.

Junk bonds, often called high-yield bonds, are a form of corporate debt issued by companies that carry a speculative credit rating of less than triple-B.

Many investors associate junk bonds with Michael Milken, who literally created the market 20 years ago while working at now-defunct Drexel Burnham Lambert in Los Angeles (and who pleaded guilty to six counts of securities violations in connection with several large junk bond transactions).

Milken theorized that if enough junk bonds were brought into the market, the returns on the ones that were paid off would outweigh the losses on the ones that failed. It didn't work out that way.

In the 1980s, corporate raiders used junk bonds to take over large corporations. But then companies like RJR Nabisco became overburdened with debt, forcing its breakup into smaller pieces.

Yet distressed lenders today are eager to point out that Milken created a market that serves a useful purpose. High-yield debt allows companies that otherwise could not borrow from traditional banks to pledge their hard assets, from real estate to equipment to inventory, in exchange for securing financing.

Yields provided by junk bonds are higher than that of higher-quality corporate bonds to compensate investors for the high credit risk associated with these securities.

In the past few years, the junk bond market has grown substantially as default rates have slowed. But with more investors entering the market, yields also have fallen.

Lenders: A slew of companies have jumped into the distressed lending market to fill the gap left by a few banks and lenders, like GE Capital, which appears to be moving toward higher-quality debt. Distressed lenders typically analyze a company and find a way to become comfortable that the structure of financing will work.

While 50 distressed lenders may have existed 10 years ago, now there are a plethora of high-yield bond funds and hedge funds that employ analysts to determine the risk-reward ratios of distressed lending.

In addition to large mutual funds, one of the first lenders in the market was Ableco Finance LLC, a unit of Cerberus Capital Management LP, of New York. Oaktree Capital Management LLC of Los Angeles, Foothill Capital Corp., a Los Angeles subsidiary of Wells Fargo & Co., Tennenbaum Capital Management of Los Angeles, Ares Management in Century City and Apollo Management all specialize in distressed debt investment vehicles.

Borrowers: Companies no longer have to be at their wits' end to qualify for junk status. It's all determined by ratios.

Basically a company that's already obligated to pay $1 in interest for every $3 in cash flow--a ratio known as interest coverage--might qualify as a junk borrower. Another metric is the amount of total borrowings against cash flow. A company with one or two times debt to cash flow would be considered high grade debt, while five times debt-to-cash flow would be considered junk.

Other factors also come into play. Newly formed companies with short histories, or those with past credit troubles and light assets, might also end up in the junk pile.

Rates: Returns for investors are determined by two variables: the coupon, or interest rate on the debt, and the price at which the debt is trading hands. Together, they make up the yield.

One year ago, distressed debt investors wouldn't touch anything that didn't have a 20 percent yield. As the economy has stabilized, investors are looking at annual returns in the high single digits and low teens.

However, in some cases returns have neared 80 percent in the past year for those who invested when rates were at their highest. Market prices, which move in the opposite direction as interest rates, have surged higher.

The market bottomed (with rates peaking) in October of 2002, when investors were afraid the economy wasn't going to pull out of its slump.

Distressed lenders charge rates of up to 20 percent to borrowers, which may include the cost of equity options and fees that can add an additional 3 percent to 5 percent to the face amount of loan.

Voices

Sabur Moini

Senior High-Yield Strategist

Payden & Rygel, Los Angeles

"In the late 1990s a lot of telecom companies should not have been raising money in the high-yield market. That caused defaults to rise, peaking at 10.5 percent last June. Since then, the market has become a lot cleaner. Defaults are down to 5.7 percent, so the market has really cleaned up its act and what are left are better-performing companies, with good operating models.

"The decline in defaults has improved the market. We're seeing the Triple-C segment as the best-performing part of the market, because there's so much money among distressed hedge funds, it's been a huge rally in the riskiest segment. That market may have gotten ahead of itself, but certainly distressed hedge funds have done quite well.

"One of the other drivers is a lot of liquidity has flown into the high-yield market, with public high-yield mutual funds taking in more than $17 billion year-to-date, because 8 percent to 9 percent yields are attractive in a low interest rate environment.

"We think it will continue to do well but not as well as the last 12 months."

Jason Reese

President

Imperial Capital LLC, Los Angeles

"The high-yield market is up dramatically, 20 to 30 percent from the bottom in October last year. Bonds that were Triple-C and below are up 60 percent in the past year. People were very pessimistic last fall, when the economy was still bad and it was pre-war. Everyone was waiting for the other shoe to drop on all the corporate scandals.

"When WorldCom came out and said it was hiding billions in EBITDA (earnings before interest, taxes and depreciation), everyone was stunned.

"The biggest problem in the high-yield market is people with money that have no place to put it right now. We'll say this bond is interesting at 80 cents on the dollar and they say, 'A year ago, I could have bought this at 40 cents.' The market has been revalued."