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Dark days for Israeli junk bond funds By Ami Ginsburg Tags: bonds, israel Government bonds are the safest investment option to be had, which means their returns tend to be on the low side. Low risk, low reward. "If you really want to outperform government bonds, you have to invest in the lepers of the corporate world too," quipped a top trader at one of Israel's leading investment firms a few months ago. He didn't mean companies like Heftsiba, where money was stolen from the company and bondholders. He meant, take a risk on companies whose bonds aren't graded by the credit rating agencies Maalot S&P and Midroog. Ungraded bonds generally yield higher interest rates than government bonds (and graded bonds), because you don't have a professional's estimate of the risk that the company will default. Moreover, the firm is more likely to default than a big, stable company. The market calls bonds like these "junk", though there is a kinder term - "high yield." Advertisement When taking a fling on junk bonds, you want to diversify. The risk of each company defaulting becomes diluted by the potential for high gains from the companies that do pay up. Say you buy ungraded bonds of 20 companies: You risk a few defaulting but assume that the rest will pay enough to compensate for the risk. Indeed, history shows that bankruptcy isn't common in Israel so over time, junk bond should return good gains. That was certainly the case eight months ago, as world markets juddered and junk bond prices dived and yields climbed as high as 20%. Investment firms smelled opportunity and quickly launched a bunch of High Yield Funds. They marketed them hard and the public bought in, investing close to a billion shekels. At the time, the public was withdrawing huge sums from regular mutual funds. They thought they'd found a new trick in the junk-bond funds. But since then, just like stocks, junk bonds seem to be seeking the bottom and haven't found it yet. From the start of 2008, the junk-bond funds have lost between 12% to 14% of their assets. Almost half of that was lost in July alone. "Corporate bonds are suffering from negative sentiment and under those circumstances ungraded bonds are hit worse," says Rami Shtairman, strategist of the "Opportunity Bonds" fund at Altshuler Shaham. What caused the downturn? It began with the companies' first-quarter reports, some of which were terrible, says Shtairman. Then came the high consumer price index figures for April and May. "Most of the companies had linked their loans to the CPI, so the more the index rose, the more their liabilities grew," he explains. The real estate companies operating outside Israel were hit on both sides: Their liabilities grew because of the high CPI and meanwhile, the value of their assets shrank because of the real estate crisis, says Shtairman. And some companies started to go broke: Nidar Construction & Development Co, for example, has taken shelter from creditors under the court's wing. And all that explains why corporate bonds fell. Yes, the intensity of the drop in ungraded bonds looks rather extreme. "At the start of the year, the spread between government and ungraded corporate bonds was 9%," says Shtairman. Investment managers thought that was wide, and would narrow over time. Today the gap is 19%. "In my opinion, a spread that wide indicates disproportionate fear," he says. In short, the level of yields indicates fear that a large proportion of the companies, about a quarter of them, will go belly-up. That isn't a reasonable scenario, Shtairman explains. Yes, some are gong bankrupt and yes, people have lost money on junk-bond funds this year: but these funds have to be judged over the long term, he urges. Ziv Shemesh, manager of "conservative" investments at Psagot, is also responsible for the Psagot High-Yield Fund Without Stocks. He agrees with Shtairman that the steepness of the fall stinks of panic. "Some of the bonds are highly illiquid," Shemesh says, which means that when you want to sell them, you can't (no buyers). A bond like that may suddenly drop 20% or even 40% on negligible turnover of NIS 20,000. Nobody's buying them except, perhaps, for the company itself buying back its debt, or the company's owner. For them it's an opportunity to buy back their debt on the cheap, he explains. But what's happened is that not only ungraded corporate bonds have taken a beating: so have high-grade bonds of top-tier companies. It's just that the drop of junk bonds was harder, Shemesh says. Rising inflation and the global crisis naturally hit hard, but local bankruptcies really didn't help. "From the year's start there were about five cases of companies that got into serious trouble, including Tao Tsuot, Dadeland Towers, Arazim and Nidar. Cases like that instill fear throughout the corporate bonds sphere, leading institutional investors to move into graded bonds or even government paper," Shemesh says. Corporate bankruptcies may have been rare in the past but that doesn't mean a thing about the future, he adds, in part because the corporate bonds market has become so big. The proportion of companies that go bankrupt in any given year is 1.5%, according to global statistics, a figure that rises to about 4% in bad years. In the realm of ungraded bonds, though, that figure rises to 12%-13% in bad years. The situation in Israel could be worse because the junk-bond sector has so many real estate companies. The proportion of bankruptcies in Israel's junk-bond sector could present could reach as high as 15%, Shemesh warns. The snowball effect can also be a problem. If a bond falls 40% in a day even though nothing in particular happened at the company, negative momentum can be created. Suppliers start to worry, banks get antsy about releasing credit. "The suppliers figure if the capital market is worried, caution is the better side of valor," Shemesh says. "If it's a construction companies, potential buyers may hesitate to close deals." The outcome can be a genuine problem. At Nidar, its owners sought court protection from creditors ahead of an NIS 2 million interest payment, which set off a positive terror. Usually companies that default do so on the principal - the actual body of the debt, not on piddling interest payments. Those aren't usually a problem for a serious company, and when it comes time to return the principal, the company usually takes out a new loan. Of course, that doesn't work in a credit crunch. But Nidar caused a wave of fear that companies will give up early, figuring it's legitimate to let the company collapse. That would be a new thing in Israel, says Shemesh. Opportunity in the junk-bond sector is greater now than at the year's start, but the risk is higher, he concludes. The only junk bond funds that's achieved positive returns for investors this year is Yelin Lapidot. It's returned a decent 6.7% while its rivals lost money. Its secret lies in its cherry-picking, explains Yair Lapidot. "In advance, we selected less risky bonds trading at double-digit yields, and had very strict rules about real estate companies." Israeli investment players shouldn't assume they can estimate how much a company's overseas assets are worth, They can't. "Property is local in nature. You have to know the country, the city, the street," Lapidot explains. How does the Yelin fund pick? Take B. Yair Building Corporation's B2 bonds. The entire NIS 84 million amount is backed by the company's mall in Pisgat Zeev, which produces operating income of NIS 11 million a year and is estimated to be worth between NIS 120 million to NIS 130 million. That's pretty solid backing. Other B. Yair bond series are trading at yield levels of 20% to 40% while the B2 is yielding just 7.2%. But it's the safer option. Other junk bond funds use statistical models, Lapidot explains. They look at the stats of bankruptcies and construct the fund accordingly. Yelin Lapidot studies each bond individually. "The behavior of the managers and their commitment to bondholders is an important part of our decision," he says. Ultimately, a major cause of the steep fall in the junk bond funds was simply a sweeping decision by institutional investors to get out of the field. That created intense selling pressure. And, says Lapidot, opportunity. "The risks are there, but in my opinion the market has over-shot the mark and the risk premiums in ungraded corporate bonds have become tremendous." Bookmark to del.icio.us   New bestsellers Three children's books about the US presidential race to be published soon. False accusation Pentagon admits it wrongly accused Jewish army engineer of spying for Israel.

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