By Harris Rubinroit

Dec. 27 (Bloomberg) -- Investors are finding junk bond yields with about half the risk in an unlikely place: the U.S. loan" market.

Borrowers with non-investment-grade ratings such as photography company Eastman Kodak Co. and tissue maker Georgia Pacific Corp. pay interest of 7.80 percent on average for loans, a quarter of a percentage point below yields on bonds with similar ratings. The gap is the narrowest in eight years, according to data compiled by Lehman Brothers Holdings Inc.

What makes loans more attractive than bonds to many investors is that they are secured by company assets. Creditors have recovered 71 percent of their principal in a default with loans, compared with 38 percent for speculative-grade, or junk, bonds, Moody's Investors Service says. Unlike bonds, the only way for most individuals to buy loans is through a mutual fund.
"The risk-return of high-yield bonds versus bank debt is out of whack,'' said Tyler Chan, a director of research for San Mateo, California-based mutual fund firm Franklin Resources Inc., who started his career in the lending department at Citibank 30 years ago. "We are telling our clients to diversify and put some of their investments in bank debt.'' Over the past 10 years loan rates have averaged 2.30 percentage points less than junk bond yields, according to Lehman. The difference was 1.47 percentage points in January. Pension funds, insurers and individual investors are joining New York-based JPMorgan Chase & Co. and Bank of America Corp. of Charlotte, North Carolina, to provide so-called leveraged loans, which swelled 62 percent to $480 billion this year.

Jumping In

Buyout firm Carlyle Group of Washington raised two funds this year totaling $1.25 billion to invest in loans. In 2005, Carlyle created one fund of $400 million. Another buyout firm, Kohlberg Kravis Roberts & Co. of New York, in March 2005 set up an affiliate to manage the first of three $1 billion funds. With loans, "the potential downside is smaller,'' Linda Pace, a managing director at Washington-based Carlyle, said at an Standard & Poor's conference on Dec. 7 in New York. "Leveraged loans are seen as a defensive investment.'' The number of institutional investors in the market for loans with ratings that are below Baa3 by Moody's and BBB- by S&P has more than doubled to 254 since 2002, according to data compiled by S&P. Two-thirds of the buyers are non-banks, up from 25 percent in 2001. Investors purchased at least $321 billion this year, up from $32 billion in 2001.

Buyout Frenzy

The borrowing is being used to finance this year's record $735 billion of debt-fueled takeovers. Nine of the 10 largest U.S. LBOs ever were announced in 2006, Bloomberg data show. New York-based. Blackstone Group LP's agreement last month agreed to buy real estate investment trust Equity Office Properties Trust of Chicago for $36 billion, and Nashville, Tennessee-based hospital operator HCA Inc. was bought for a record $33 billion by a group including KKR. The last time an LBO exceeded the $30 billion mark was in 1989, when KKR paid $31.1 billion for RJR Nabisco Inc. Loans are arranged by banks and securities firms, which then syndicate, or sell, pieces to investors. JPMorgan is the biggest arranger, with an 18.7 percent market share, and Bank of America is second with 14.4 percent, data compiled by Bloomberg show. The appeal of loans increased as short-term borrowing costs, which determine bank rates, began to rise above long-term costs, the benchmark for bonds. The three-month London interbank offered rate, an average of rates set daily by U.K. banks, is 5.36 percent, up from 1.58 percent in mid-2004, when the Federal Reserve began raising its target interest rate for overnight loans between banks. The 10- year Treasury note yields 4.65 percent, down from 4.87 percent.

Refco's Recovery

"On a relative value basis, leveraged loans are more attractive than high-yield bonds,'' said Seth Katzenstein, a New York-based managing director at GSC Group, which manages more than $18 billion in bonds and bank credits. Loan investors in Refco Inc., the futures trader that in October 2005 filed the 15th biggest bankruptcy in U.S. history after Chief Executive Officer Phillip Bennett was accused of fraud, recovered all their principal earlier this year, according to S&P. Bondholders received about 83 cents on the dollar. Bennett pleaded not guilty to federal fraud charges in November 2005 and is awaiting trial. Kodak, based in Rochester, New York, is paying a rate of 7.2 percent on its loans, the same as the yield for its bonds, Morgan Stanley data show. Atlanta-based Georgia Pacific loan rates average 7.23 percent, compared with 7.24 percent for its bonds.

Biggest Difference

The loan rates for Affiliated Computer Services Inc. of Dallas, the world's biggest processor of student loans, exceed its bond yields by the most of any company tracked by Morgan Stanley: 7.16 percent versus 6 percent. Next is Huntsman LLC, which is run from Salt Lake City and Houston. Its loan rates average 7.05 percent, compared with 5.93 percent on its bonds. New York Life Investment Management LLC, a unit of New York Life Insurance Co., has set up accounts for its clients to invest in high-yield loans. The New York-based firm oversees almost $5 billion in bank
debt, up from $2.5 billion in October 2004. Investor demand for loans "has picked up,'' said Robert Dial, head of leveraged loans at New York Life Investment Management. "We have seen significant growth on all fronts.'' So much money is available that investors are lowering their standards. S&P says loan market debt exceeded cash flow, a measure of profit before interest and depreciation, by an average of 5.2 times in the third quarter, the most in four years. About 54 percent of loans sold to investors are rated B+ or lower, up from 42 percent at the end of 2004, S&P estimates.

'Covenant-Lite'

Restrictions, or covenants, in lending agreements designed to protect creditors "have deteriorated markedly over the past few years,'' said William May, a senior director in credit market research at Fitch Ratings in New York. Freescale Semiconductor Inc., the Austin, Texas-based chipmaker that was bought on Dec. 1 by a Blackstone-led group in a $17.6 billion LBO, obtained a $3.5 billion loan that sets no quarterly limit on the amount of debt it can have relative to cash flow. The seven-year term loan pays interest at 2 percentage points above Libor, or about 7.36 percent, a quarter of a percentage point below what the company first offered investors. Investors call financings such as Freescale's "covenant- lite.'' Some $24.1 billion of such loans were made this year, triple the amount in the previous eight years combined, S&P said. "These trends, coupled with the increased use of leveraged loans going forward may affect recoveries,'' May said.

Few Concerns

Investors aren't worried about companies failing to pay their debts these days. The default rate for speculative-grade debt was 1.9 percent in October, below the average of 5 percent since 1970, Moody's says. The U.S. economy will accelerate to a 2.9 percent annual rate by the end of 2007 from 2 percent this quarter, according to the median estimate of 79 economists surveyed by
Bloomberg from Dec. 1 to Dec. 8. "Leveraged loans are still perceived as the best game in town for risk-adjusted returns in the fixedincome market,'' said Steven Bavaria, vice president in loan and recovery ratings at S&P in New York. "If the credit market does turn, at least you're secured,'' he said. The loan market is unlikely to slow because buyouts are increasing, said Anthony Clemente, head of New York-based Canaras Capital Management LLC, who has invested in loans since 1989. "Loan issuance in 2007 should rise by approximately 20 percent over 2006,'' said Clemente.

'$50 Billion' LBO

Leveraged buyout firms have $1.6 trillion to spend on debt- financed acquisitions, Morgan Stanley estimates.

"We could see a $50 billion buyout in 2007'' because of the money flowing into loans, said Jonathan Insull, a managing director at New York-based TCW Asset Management Co., which oversees almost $4 billion in bank debt. The firm is a unit of TCW Group Inc., which manages about $140 billion for investors.

The head of credit strategy research at Bank of America's securities unit, Jeffrey Rosenberg, predicted last December that the biggest LBO this year would probably reach only $20 billion. Like Insull, he now says a $50 billion deal is possible. HCA's buyout was financed in November with the help of an $8.8 billion loan, the biggest ever sold to institutional investors.

'The New Bonds'

Many investors are putting money into loans through collateralized loan obligations, the same type of funds as those set up by Carlyle and KKR. Canaras is forming its first CLOs, said Clemente.
"CLOs are the biggest source of demand,'' said Daniel Toscano, head of senior debt capital markets in New York at Deutsche Bank AG, which arranged the loans for the $15 billion buyout of rental car company Hertz Corp. last December.

CLOs typically buy 100 to 200 leveraged loans, and are divided into portions of varying risk that are sold to investors including insurers, pension funds and hedge funds. The amount of CLOs created rose to $86 billion in the first 11 months of this year, from $46 billion in the same period a year earlier, according to S&P.

"Loans are the new bonds,'' Brian Arsenault, a high-yield debt strategist at Morgan Stanley in New York, wrote in a Dec. 14 research report to clients.