The riskiest reaches of the bond market have enjoyed a comeback this year, after a bruising sell-off in 2015. But few “distressed debt” hedge funds have managed to capture the rally.
These hedge funds ply their trade in the lowest-rated corporate bonds, betting against companies that are about to go bust or wagering that others might recover. This year initially started as badly as 2015 ended, thanks to a global market swoon, but since then the returns shown in indices have been eye-watering.
Distressed junk bonds have gained a third this year, according to a Bank of America Merrill Lynch index, and the broader US junk bond market has returned 13.5 per cent. But Hedge Fund Research’s index for the distressed debt hedge fund industry has only risen 6.2 per cent up to the end of July.
“The performance of most of the distressed debt sector has been pretty insipid, given the recovery and compared to most high yield funds,” says Victor Khosla, the head of Strategic Value Partners.
Mr Khosla’s main fund is up 10 per cent after losing 5 per cent in 2015, but others have fared worse. A Credit Suisse index of the bigger hedge funds in the space is only flat for the year, and distressed debt industry insiders say many of the best-known players have failed to ride the recovery.
The main challenge has been riding a turbulent energy bond market, which moved sharply lower in January and February, before snapping back this spring, wrongfooting many hedge funds. Many of the bigger players are also often more focused on big distressed situations like Harrah’s, Claire’s or iHeart Radio, which haven’t recovered.
But some funds have enjoyed a good year. Perhaps the biggest comeback is Jason Mudrick’s Distressed Opportunity Fund, which was one of the worst-performing hedge funds in the world last year, losing 25.7 per cent. But this year it has returned almost 29 per cent up until August 5.
“Distressed was tough last year,” Mr Mudrick says. “A lot of what happened in the back half of last year hurt less-liquid assets, and distressed by its nature is less liquid, so a lot of the forced selling we saw out of mutual funds . . . really hurt the mark-to-market of a lot of distressed portfolios. Now you flip to this year, a lot of those losses were just that — they were mark-to-market.”
Investors also seem to be warming up to the industry again. Distressed debt was one of only four strategies in the hedge fund universe that seemed primed to attract investor interest and allocations over the next six to 12 months, according to a recent survey by Barclays’ prime brokerage group.
The interest is driven by a sharp recovery in the prices of the junkiest of junk bonds, and a paucity of opportunities elsewhere. US corporate debt rated “triple-C” — the lowest rung of the rating agency scale -— has returned almost 25 per cent already this year, after losing over 15 per cent last year.
Risky debt has also been helped by technical factors, such as its illiquidity — which means bonds can move sharply up or down on fairly moderate changes in demand — and a lack of fresh supply. This year’s triple-C issuance of $ 12.2bn is the lowest as a percentage of broader junk bond sales since 2003, according to Goldman Sachs.
For traders wrongfooted previously, this may be the last chance to get it right, says Ankur Keswani, head of corporate credit at Serengeti Asset management, as investors may not have the patience or stomach to weather another period of underperformance.
“People have just gotten whipsawed in energy,” she says. “If you missed the opportunity in energy last time, that opportunity is coming back, so wake up now, don’t wake up when everybody’s frozen and not doing anything — take advantage of the opportunity as it starts to build.”
But the prospects may be souring once more. The trajectory of prices for triple-C bonds has stalled recently, as oil prices approached their lows for the summer early in August. In fact, there has been a sharp and notable divergence between the relative resilience of the riskiest slices of corporate debt and the renewed energy slump, which could indicate trouble ahead.
Moreover, the slump in triple-C issuance could lead to problems if it means weaker companies struggle to raise money to roll over bonds maturing this year. “It’s a Catch-22 situation,” says Stephen Caprio, a strategist at UBS. “If we don’t get more issuance eventually it will lead to refinancing issues.”
Default rates are still ticking up, and a recent S&P report highlighted how the median debt burden of non-investment grade US companies has reached a new record this year, even as the average cash reserves to cover interest payments has slipped to the lowest since at least 2006.
Mr Khosla believes that the rally will open up the issuance market for lowly-rated companies, but doubts that distressed debt returns will bounce back to those seen in the wake of the financial crisis. “The opportunity set is decent, but not amazing.”
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