Returns from debt securities issued by companies that have defaulted or are close to defaulting are down from their double-digit gains of last year, but distressed debt is still a bright spot for investors
Returns from debt securities issued by companies that have defaulted or are close to defaulting are down from their double-digit gains of last year, but distressed debt is still a bright spot for investors.
Hedge funds that invest in speculative-grade bonds advanced 7% on average for the first nine months of the year, according to Hedge Fund Research Inc. That trumps the Dow Jones Industrial Average's 3.5% return during the same period.
These hedge funds advanced an average of 28% last year, compared with 23% for the Dow. But distressed-debt hedge funds declined in 2008, dropping 25% on average, according to Hedge Fund Research.
Distressed debt sells at a very low percentage of its face value.
These investments pay off if the once-distressed company successfully emerges from bankruptcy. Its debt then sells for higher prices, thus earning large gains for investors.
“Results have been very strong, and we've been seeing more interest from investors,” said Steve Persky, chief executive of Dalton Investments LLC, a hedge fund that has $1.3 billion invested in distressed debt, and Asian and other global equities. Interest in these risky investments comes mostly from foundations, pension funds and high-net-worth families who are looking for diversification, he said.
FOCUS ON MBS
Most of the $550 million that Dalton Investments has in distressed debt involves mortgage-backed securities, a specialty at the firm. Dalton Investments hired a team from failed lender Countrywide Financial Corp. with experience with distressed real estate securities, Mr. Persky said.
Bank of America Corp. bought Countrywide in 2008.
The team has found new opportunities without leveraging, Mr. Persky said.
“It's a value proposition for our investors — added diversification and higher returns, with no leverage,” he said.
Some financial advisers also have noticed the added diversification — and recently the rewards — of distressed debt.
Financial adviser Andrew Palmer of Bel Air Investment Advisors LLC, which manages about $4.5 billion in client assets, invests about 5% of his client portfolios in distressed debt. So far this year, the strategy he employs has returned about 10% for clients; last year, it returned 35%.
“Distressed debt comes in and out of vogue,” Mr. Palmer said. “It's still good trade for another year or so.”
Mr. Palmer said that he spends a lot of time explaining the risks and benefits of distressed debt to clients and usually has to educate them generally about hedge funds, which sound scary to clients.
“We use it as a tactical move, not a long-term strategic move,” he said.
Market experts said that the level of distressed corporate debt has fallen from its highs but should remain steady in the near term.
The percentage of corporate debt trading at distressed levels is 12%, lower than the its long-term average of 15% and well below its all-time high of 85% in December 2008, according to Standard & Poor's.
STEADY SUPPLY SEEN
Diane Vazza, managing director of global fixed-income research for S&P, said that the supply of distressed corporate debt has dwindled since last year, but it is expected to remain at the current level over the next 12 months, depending on the economy.
“We are talking about the weakest-rated companies, so their ability to weather a feeble recovery is questionable,” she said.
Media and entertainment companies are the dominant sectors in the distressed market, accounting for more than 30% of September's total distressed issues, according to S&P. The restaurant/retail sector is second, with 12.7% of the distressed issues for September.
Some market professionals expect that the distressed-debt market will swell again soon.
“This is a breather in the distressed markets before we see a lot more defaults,” said George Putnam, chairman of New Generation Research Inc., which maintains a website of bankruptcy information and advises private clients on distressed-debt investments.
The market for high-yield bonds overall has rebounded “very quickly,” he said. In fact, that market is at a record high of $263.5 billion globally, 26% above the record set for the full year of 2009, according to Bloomberg LP data. About $208.9 billion of the junk bond sales have been in the United States.
A reasonable fraction of those companies will fail, “and even if it is a small fraction, it will result in a large amount of distressed securities,” Mr. Putnam said.
