Companies left behind in the biggest U.S. bond-market rally ever are catching up as investors from Legg Mason Inc. to New York State's biggest pension fund seek an alternative to junk-bond yields at record lows.
The gap in borrowing costs between the smallest companies with limited access to capital markets and bigger firms that can offer bonds shrank to the least this year, according to Standard & Poor's Capital IQ Leveraged Commentary & Data. Relative yields on loans to borrowers with earnings of $50 million or less fell to 74 basis points more than those of the biggest companies on Aug. 16, from 1.27 percentage points in January.
Legg Mason, the Baltimore-based money manager, is starting a fund to invest in loans to so-called middle-market companies, joining Tennenbaum Capital Partners LLC and the New York State Common Retirement Fund. The funds are proliferating as the Federal Reserve says it expects to hold interest rates near zero through at least late 2014.
“The middle market right now is extraordinarily competitive,” said E.A. Kratzman, president of Katonah Debt Advisors LLC in New York. The most-active investors “are willing to take down very, very large swaths” of loans to the smallest issuers, he said.
Those corporate borrowers, which typically haven't had access to the $4.8 trillion U.S. market for company bonds, are attracting investors even as the U.S. unemployment rate held above 8% in July for a 42nd month.
The Fed's latest quarterly survey of senior loan officers at banks released Aug. 6 said while lenders loosened standards for loans to large and midsize firms, those for small business were little changed for the fourth consecutive period.
“The market has a lot of growth in front of it,” said Chris Flynn, a managing director at THL Credit Advisors LLC, the $2.8 billion debt investment arm of private equity firm Thomas H. Lee Partners LP. “It's much more of an originate buy-and-hold market given the lack of liquidity than what you see in the broader debt market.”
With its new fund targeting the smallest corporate borrowers, Legg Mason is seeking to profit in a business Wall Street largely abandoned after the credit crisis in 2008. Its new closed-end fund aims to give investors their money back after eight years, according to an Aug. 10 prospectus filed with the U.S. Securities and Exchange Commission.
It's seeking to boost returns by investing in debt that isn't frequently traded such as the corporate-bond market, where average yields on U.S. speculative-grade securities have dropped to 7.4%, 20 basis points from the record low reached in May 2011 based on Bank of America Merrill Lynch index data.
Those securities have returned 108% since 2008, the biggest four-year rally since Michael Milken helped create a market for the securities in the 1980s.
Middle-market companies “typically have shorter operating histories, narrower product lines and smaller market shares than larger businesses,” with less predictable income and ability to raise debt, Legg Mason said in the prospectus for the fund, which will be managed by its Western Asset Management Co. unit.
Smaller companies “have been forced to find alternative funding sources and are willing to pay a high interest rate and include covenant features which benefit investors,” according to the filing. Banks “continue to restrict their lending activity, particularly to small and mid-sized corporations.”
Investors generally demand higher yield premiums for debt that isn't traded frequently because it's more difficult to sell if the creditworthiness of the borrower deteriorates or if the investor needs to raise cash quickly.
Tennenbaum Capital, a $4.5 billion credit investor in Santa Monica, Calif., is also raising money to invest in middle-market debt, according to the San Bernardino County Employees' Retirement Association, which was considering investing in a middle-market fund.
The New York State Common Retirement Fund, with about $150.3 billion of assets, committed money for the first time this year to funds from Brightwood Capital Advisors LLC and Monroe Capital Corp., according to a February monthly transaction report.