February 10, 2012 / 4:40 PM / 8 years ago

Demand for yield, ETF appetite drive junk-bond market

Feb 10 (IFR) - As spreads continue to ratchet lower, demand for ever riskier paper is propelling some investors to look for better odds in the gaming sector, where Casino operators such as Caesars are capitalising on investors’ willingness to grab yield and liquidity, at times with little regard for credit fundamentals.

Formerly Harrah’s Entertainment, Caesars Entertainment Corp , the US casino chain and owner of the famed Caesars Palace, on Thursday priced the largest junk bond deal from this challenging sector in more than 18 months, selling US$1.25bn in 8.5% eight-year non-call four senior secured notes as part of its debt refinancing efforts.

There was purportedly no shortage of demand for the bonds, with industry insiders suggesting the deal attracted more than $4bn of demand.

But some are concerned that the success of the Caesars deal was not entirely based on a belief in its credit story, but rather because of a chase for yield and increasingly because of the impact giant passively managed ETFs are having on the market.

“Investors are absolutely putting in orders into deals like Caesars because they know a passive ETF like an HYG or a JNK needs to buy these bonds,” said David Flaherty, a senior portfolio manager at Peritus Asset Management, which runs is an actively-managed ETF in Santa Barbara, California.

The iShares iBoxx High Yield Bond fund (HYG), SPDR Barclays Capital High Yield (JNK) and Powershares High Yield Corporate (PHB) are the three biggest ETFs in the US high yield bond market. According to Citigroup, ETFs in the US high yield market now have more than $22bn of assets, a 50% jump in size from the beginning of 2011.

HYG and JNK are the largest, with more than $10bn of assets each, according to industry participants. Their investment objective is primarily to match a benchmark index’s performance, while actively-managed ETFs and mutual funds will seek to out-perform an index.

Most of the time the passively managed ETFs buy bonds in the secondary market, after an index is balanced on a monthly basis. But HYG and JNK have the discretion to come in and buy a large deal, like a Caesars, in anticipation that it will end up in the index against which they benchmark themselves.

That means other investors will buy into an index-eligible deal, in anticipation that there will be a strong bid for the securities from the ETFs, either at the primary level, in the secondary market, or both.

Michael Anderson, a credit strategist at Citigroup, says that the influence of ETFs on the market is undeniable and widespread.

“The influence has been especially acute in 2012 as ETF inflows accelerated and comprised an increasing percentage of overall mutual fund inflows,” said Anderson.

He said the ETFs usually own nearly all the bonds in the liquid benchmark and rarely own non-benchmark bonds.

There’s nothing new about hedge funds and other investors jumping into a large deal at the primary level because they know large mutual funds indexed to a benchmark will be looking for those bonds.

The difference here, however, is the size of the ETFs and the fact that they’ll be looking to buy index-eligible bonds, regardless of the issuer’s fundamentals.

“We call the big passive ETFs, the black box. They just go in and buy. There is no credit work or fundamental analysis done,” said Flaherty. “That’s just the way they work. They just follow an index.”

Caesars was able to build a large book, despite having been forced to delay the offering by a day, after reportedly facing resistance from loan investors on a proposed amend and extend (A&E) to its existing bank credit facilities.

The bond deal was contingent on certain conditions, including completion of the Caesars’ proposed bank amendment, which sources say required approval by at least 51% of Caesars’ first-lien loan holders. Some sources also maintained that bond underwriters on the debt offering reached out to the issuer’s loan investors in an attempt to persuade them to approve the A&E deal.

Proceeds of the bond deal will be used to repay approximately US$1.0bn of the B1-B3 first lien term loans, revolving loans converted to term loans, to pay transaction fees, and for general corporate purposes.

JPMorgan, Bank of America Merrill Lynch, Citi, Credit Suisse, Deutsche Bank, Goldman Sachs and Morgan Stanley acted as joint bookrunners on the sale.

The company also sold 1.81 million shares at USD9 per share in an initial public offering on Tuesday.

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