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Trouble brewing in high-yield debt, commodity investor warns

Bay Street signs are seen in the heart of the financial district in Toronto, Aug. 17, 2009..

© Mark Blinch / Reuters

The market for high-yield mining and energy debt is suffering from the some of the same issues that sparked the 2008 crisis as investors turn a blind eye to poor credit in their desperation for fatter returns, according to an executive with one of Canada's largest hedge funds.

Fund managers are snapping up lower-quality debt in a bid to outperform their competitors and retail investors don't understand the underlying credit risk, particularly in exchange-traded funds, said Rick Rule, chief executive officer of Sprott U.S. Holdings Inc., a subsidiary of Toronto-based Sprott Inc. with $9.2-billion under management.

"It wouldn't take anything at all to have the same circumstance occur in mining and energy junk debt that happened in mortgage securities," Mr. Rule said in an interview in Toronto Monday. "Remember that nothing precipitously changed in the housing market in 2008. It's just that people began to do the arithmetic."

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Rule sees a similar thirst for yield driving investors into junk debt that pushed investors into subprime mortgages, which ultimately blew up, helping to touch off the financial crisis. High-yield bond spreads hit a 32-month low last week, according to the Bloomberg Barclays High Yield Index. Energy bonds have returned 51 per cent over the past year, the best-performing industry, according to a Bank of America Merrill Lynch index.

Any kind of lack of faith in credit or another downturn in the price of oil and gas could trigger a 2008-type crisis, Mr. Rule said. A rise of 200 basis points in the U.S. 10-year Treasury, currently at 2.5 per cent, could also cause "cracks" in the high-yield market, he said.

More Trauma

The risks are exacerbated by exchange-traded funds as they've become bigger buyers of high-yield deals, including smaller issues of $150-million to $200-million, said Mr. Rule, who was attending the Prospectors & Developers Association of Canada convention, the world's biggest mining gathering. While ETFs are extremely liquid the underlying debt securities are not, making it hard to find buyers if investors decide to decamp, he said.

"The credit markets are the most generous I've seen them in my entire life," Mr. Rule said. "The credit markets should be experiencing more trauma in resource lending than they are."

Sprott is also a beneficiary of that hunt for yield. The company raised $880-million for a credit fund that will structure loans to junior mining companies that need project capital, Rule said. Last March they company expected to raise $400-million by the end of 2016.

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