US junk bond rally pauses as investors take profits

NEW YORK Aug 18 (Reuters) - Profit-taking is letting the steam out of a U.S. junk bond rally and causing the first cracks in the new issue market in weeks as investors reassess their appetite for risk.

Junk bond yield spreads widened to their highest levels since July on Monday after U.S. stocks suffered their worst loss in seven weeks amid concerns about the global economy's health.

While stocks rebounded on Tuesday, junk bonds were mixed, with some higher-priced bonds still under pressure and trading flows thin.

"The bleeding feels like it's stopped, but there's not a full-out rally either," said Scott Grzankowski, analyst at high-yield research firm KDP Investment Advisors.

Even after a downturn that started early last week, junk bonds are turning in one of their strongest years ever, with returns approaching 39 percent year to date, according to Merrill Lynch data. Voracious demand for high-yielding debt may mean that the recent pullback is only a breather after the rally pushed prices to levels too high to sustain, traders said.

PRICE SHOCK AFTER RALLY

"There are a lot of names that have had just a heck of a run, and how much more can people push paper up in dollar price?" said Christopher Munck, high-yield trader at B. Riley & Co in Los Angeles. "It can't go up forever, and people are going to hold back."

Junk bond prices on average have rallied to over 86 cents on the dollar from less than 59 cents in early March, according to Merrill Lynch data. Many bonds are trading above par and some as high as 114 cents, according to MarketAxess.

Junk bonds have rallied on relief that the economy was recovering from the worst downturn in over 70 years, but recent signs of consumer weakness have reminded investors that recovery prospects are uncertain and may not justify the massive gains in riskier debt.

"The truth is the credit markets have backed up a very large amount the last couple of weeks," said Guy LeBas, chief fixed-income strategist at Janney Montgomery Scott in Philadelphia. The high-yield credit default swap index has fallen by 4 percentage points in price in a week and a half, "and that's a sharp move," he said.

"We're not looking for another dramatic retrenchment to March levels, but we could see further downward movement from here," LeBas said. Recognition that economic fundamentals remain weak and heavy refinancing needs of high-yield debt issuers could keep pressure on the market, he said.

Recent profit-taking has already taken a toll. Yield spreads on junk bonds have risen to 917 basis points over Treasuries, up nearly 60 basis points from a week ago, according to Merrill Lynch data. Spreads widen when investors demand more compensation for the risk of owning junk bonds.

DOLE PULLS BOND SALE

In the wake of rising spreads, Dole Food Co on Monday postponed a $325 million junk bond sale because of market conditions, according to IFR, a Thomson Reuters service.

The debt sale by the world's largest producer of fresh fruits and vegetables will likely be rescheduled in the "relative near term," high-yield research firm KDP Investment Advisors said in a research note on Monday.

While one pulled sale is not a cause for concern, investors are keeping a close eye on the new issue market as a way to gauge investor sentiment.

"One of the big themes in the high-yield market has been get out there while you can, especially for issuers that have debt maturities coming due in 2010," said LeBas of Janney Montgomery Scott.

"We're seeing high-yield issuers coming out months in advance of their maturities to prefund them," he said. Any perception that the market is weakening could result in a bigger rush to issue, which would cause companies to increase the yield concessions they pay to get deals done, he said.

Year-to-date, junk-rated companies have sold more than $81.6 billion of bonds, twice the amount sold in all of 2008, according to Thomson Reuters data. More than $13 billion was issued last month, the busiest July ever.