Two L.A. Firms Start to Clean Out Some Junk

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Two L.A. Firms Start to Clean Out Some Junk
Sit Up: Jamie Farnham at TCW Group’s offices in downtown Los Angeles.

Investors desperate for returns are fueling a boom in junk bonds, pushing their yields to historic lows. But portfolio managers at two of L.A.’s biggest financial firms believe the mood is overly exuberant and in recent months have taken a step or two back from the riskiest bonds in the junk world.

Jamie Farnham, a portfolio manager for the High Yield Bond Fund at TCW Group in downtown Los Angeles, which was No. 3 on the Los Angeles Business Journal’s list of the largest money managers in Los Angeles in the June 2 issue, thinks it’s time to get conservative, and he’s reallocating his portfolio to get away from the lowest-rated junk bonds.

“Essentially, the market is charging less for more risk,” he said. “Typically, that is a good time to get defensive.”

At downtown’s DoubleLine Capital (No. 8 on the list), portfolio manager Bonnie Baha sees U.S. junk bonds, given their high-risk profile, as not particularly enticing considering other options that pay just as much.

“If we’re going to put our money to work in assets with a noninvestment grade rating, we still think there’s better value elsewhere than in corporate high-yield bonds at the present time,” she said.

Interest in noninvestment-grade bonds is surging right now for two major reasons. One, anemic yields in safe investments, which show no sign of rising anytime soon, are pushing investors toward more speculative stuff. And two, commercial banks have largely gone away from making cash-flow loans to many businesses, leaving expensive third-party lenders and the bond market to fill in the gap.

That’s led to companies desperate for cash and investors lusting for any type of yield in this depressed market finding each other at the junk-bond saloon. And just like at the real-life saloon, some of these matches don’t always make much sense.

“Deals are getting done that under any other circumstances probably shouldn’t even be able to come to market,” said Baha.

Junk bonds, which are the colloquial term for high-yield, noninvestment-grade corporate bonds, are bonds rated below BBB- or Baa3 by the rating agencies. The questionable creditworthiness of the companies issuing these bonds prevents commercial banks from investing in them, leaving them to folks with a higher appetite for risk.

The Bank of America Merrill Lynch U.S. High Yield Master II index, which has tracked average U.S. junk bond yields since 1997, hit an all-time low of 5.2 percent June 23. At the same time, net flows into high-yield mutual funds, such as the one Farnham manages, have increased by $6.1 billion this year, according to data from Lipper, a subsidiary of Thomson Reuters in New York.

At TCW, Farnham’s approach has been to go up in quality while remaining in the high-yield world. His fund, which manages about $36 million, has been expanding its position in the higher credit tier of junk bonds and reducing its position in more speculative products recently.

While this might sound a little bit like choosing cake over ice cream at the dessert buffet, Farnham said there are key distinctions that make some noninvestment-grade bonds much safer than others. For example, he believes bonds rated CCC, which is the lowest rating that can be given to debt that isn’t actually in default, do not offer much upside to investors given their current yields and high default risk, and has repositioned his portfolio accordingly.

“The risk-reward tradeoff isn’t particularly favorable at this point,” he said.

Baha at DoubleLine doesn’t think junk bonds are priced irrationally given the depressed yields found everywhere, but she also doesn’t see them offering much value to investors considering the alternatives. So rather than chase 5 percent yields in low-rated U.S. corporate debt, DoubleLine has chosen to bet on certain mortgage-backed securities and blue-chip companies in emerging markets.

DoubleLine’s bread and butter investments, on which its founder Jeffrey Gundlach built his reputation, are securities backed by home loans that are not guaranteed by the federal government, and they deliver yields similar to junk bonds. They also don’t carry an investment grade – some outlets have erroneously classified them as junk bonds – but are underwritten based on the characteristics of large pools of homeowners and not corporate balance sheets. Baha sees more upside in these mortgage-backed securities than noninvestment grade corporate debt.

Baha also said that the debt of high-quality, investment-grade corporations such as Pemex, Mexico’s national oil company, has delivered favorable returns compared with that of some American businesses. She thinks many American investors need some time to get comfortable with economies such as Mexico’s, but there’s still value to be found there.

DoubleLine’s core fixed-income fund keeps less than 3 percent of its assets in junk bonds, but it has also recently gone underweight on bonds in the lower tiers of noninvestment grade debt. Their yields, which can approach 10 percent, are tantalizing, but Baha thinks the risk isn’t worth it.

“To have an overweight in that rating category doesn’t strike me as being very prudent right now,” she said.

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