U.S. pension-plan managers are pouring cash into debt from thesmallest speculative-grade borrowers, seeking to meet targeted 8percent returns at a time when average yields are at about recordlows.

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California's San Bernardino County Employees' RetirementAssociation, which oversees $6.1 billion, is poised to recommendinvesting in a fund from Tennenbaum Capital Partners LLC thatexclusively focuses on lending to smaller companies. The New YorkState Common Retirement Fund, with about $150.3 billion of assets,committed money to funds from Brightwood Capital Advisors LLC andMonroe Capital Partners LP this year.

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Fund managers that oversee retirees' health and pension benefitsare seeking the debt of smaller junk-rated borrowers, pushed towardriskier investments as the Federal Reserve pledges to hold interestrates near zero through 2014. Borrowers with $500 million or lessin annual revenue are paying disproportionately higher yields asU.S. banks reduce commercial and industrial lending by 12 percentfrom the 2008 peak.

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“We like this space,” Donald Pierce, chief investment officer ofthe San Bernardino County pension plan, said in a telephoneinterview. “This segment of the marketplace is having a tough timeaccessing capital,” he said.

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Middle-market loans have average yields of 7.8 percent comparedwith 6.6 percent on large corporate obligations, according toStandard & Poor's Capital IQ Leveraged Commentary & Data.S&P LCD defines middle market as issuers with earnings beforeinterest, taxes, depreciation and amortization of $50 million orless.

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Loans to smaller companies had a 12-month trailing default rateof 1.25 percent in May, compared with 1.05 percent for biggercompanies, according to S&P LCD.

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Pension plans are poised to play a bigger role in financing thesmallest companies after banks reduced commercial and industrialloans and leases to $1.4 trillion as of May 30, from $1.6 trillionon Oct. 22, 2008, according to Fed data.

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“The strategy is definitely getting traction,” said FrankBarbarino, a consultant with NEPC LLC, an investment adviser. “It'sthat magic 7 to 8 percent number that institutions are shooting forat the plan level. Many are willing to lock up their capital for afew years in order to add strategies that help them get there.”

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Elsewhere in credit markets, the cost of protecting corporatebonds from default in the U.S. rose, with the Markit CDX NorthAmerica Investment Grade Index, which investors use to hedgeagainst losses or to speculate on creditworthiness, climbing by 0.9basis point to a mid-price of 124.3 basis points as of 11:24 a.m.in New York yesterday, according to prices compiled byBloomberg.

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Bondholder Protection

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The index typically rises as investor confidence deterioratesand falls as it deteriorates. Credit-default swaps pay the buyerface value if a borrower fails to meet its obligations, less thevalue of the defaulted debt. A basis point equals $1,000 annuallyon a contract protecting $10 million of debt.

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The U.S. two-year interest-rate swap spread, a measure of bondmarket stress, declined 0.03 basis point to 30.18 basis points asof 11:24 a.m. yesterday in New York. The gauge narrows wheninvestors favor assets such as corporate bonds and widens when theyseek the perceived safety of government securities.

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Bonds of Brazil's Embraer SA are the most actively tradeddollar-denominated corporate securities by dealers today, with 60trades of $1 million or more as of 11:26 a.m. in New York,according to Trace, the bond-price reporting system of theFinancial Industry Regulatory Authority. The world's fourth-biggestplane-maker sold $500 million of 5.15 percent, 10-year bondsyesterday.

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San Bernardino's pension plan, attracted by bigger yields andmore favorable covenants, is setting its sights on the smallestborrowers as it faces an actuarial rate of 7.75 percent, Piercesaid. Pensions for public employees typically trail the 8 percentaverage yearly gains that officials set as their benchmark to coverrising costs.

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The New York State Common Retirement Fund allotted money for thefirst time this year to funds from Chicago-based Monroe and NewYork-based Brightwood Capital, which is led by Damien Dwin andSengal Selassie. Both firms focus on investing in smallercompanies.

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Pennsylvania's Public School Employees' Retirement Board, whichoversaw $50.8 billion as of March 31, 2011, agreed in March toinvest as much as $200 million in Cerberus Institutional Partners VLP.

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The fund will buy “distressed assets on a global basis” andinvest in “private-equity turnarounds focused on the middlemarket,” according to a Feb. 16 letter to the pension plan'strustees from Portfolio Advisors LLC, recommending theinvestment.

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“All these pension funds have a huge issue right now: they needto hit a 7 to 8 percent annual return in order to hit theiractuarial needs,” said Theodore Koenig, Monroe Capital's chiefexecutive officer. “The market isn't giving them that.”

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Demand for the debt comes as smaller companies seek a place toborrow. Issuance of loans to the smallest companies has declined to$3.77 billion for the first five months of the year, compared with$7.59 billion during the comparable period in 2011, the S&P LCDdata show. In the first five months of 2007, the borrowers sold$15.3 billion of loans.

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“In the large-cap market, the maturity wall has been pushed outwith the ability to issue high-yield debt in 2011 and 2012,” MonroeCapital's Koenig said. “In the middle market, that has not been thecase.”

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'Pulled Away'

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About $130 billion of loans that are less than $100 million eachare coming due in the next five years, according to NewstarFinancial Inc.

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“The banks have pulled away in fairly significant ways over thepast several years although they're returning to the market in somecapacity,” Barbarino said. “Middle-market loan volumes are down,and banks are focused on larger companies.”

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Corporate bonds and loans set to mature through 2014 tumbled 66percent to $413 billion as of last September from $1.2 trillion atthe end of 2008, according to JPMorgan Chase & Co.research.

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U.S. leveraged loan issuance has totaled $257.7 billion thisyear and $603.6 billion in 2011, Bloomberg data show. U.S. junkbond sales have totaled $138.5 billion this year.

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Issuance of collateralized loan obligations may reach $30billion this year, JPMorgan said in April. That's down from $91.1billion at the peak of the market in 2007, according to Bloombergand Morgan Stanley data. CLOs buy high-yield, high-risk loans,including those from smaller companies and slices them intosecurities of varying risk and return.

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“We have seen a couple of new entrants in the market, but as youknow, the middle-market lender universe has been thinneddramatically over the past few years,” said Timothy Conway,Newstar's chief executive officer, in a May 2 earnings call.

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Pension plans are facing “lackluster” returns in 2011 thatweren't sufficient to offset rising liabilities, causing fundinggaps that are poised to widen, according to a Feb. 14 Fitch Ratingsreport.

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The California Public Employees' Retirement System, the largestU.S. pension, has seen its market value decline 4.8 percent thisyear after stocks fell amid the brewing fiscal crisis in Europe andslowing of the U.S. economic recovery.

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Investment-grade bonds yield 3.49 percent, according to Bank ofAmerica Merrill Lynch index data, while U.S. Treasury 10-year notesare at 1.66 percent. Including reinvested dividends, the S&P500 has returned 6.3 percent this year after gaining 2.1 percent in2011.

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“Pension plans are really looking to expand the list of approvedinvestments,” said Mark Oline, Fitch Ratings' global head ofcorporate ratings in Chicago. “Secured loans were not very commonin the asset list but are gaining favor in portfolios.”

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Bloomberg News

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