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29 February 2024

Risk ahead for corporate debt

Markets are still only a third of the way through the distressed cycle, according to experts. (AFP)

By Claire Milhench

Investors queueing to pour cash into discounted corporate debt are in for a risky ride as hedge funds continue to dump assets on the market and default rates have yet to peak.

There is rising interest from private equity and hedge funds to scoop up debt in secondary markets. Last year leading lights Mark Devonshire and Mark McGoldrick left Merrill Lynch and Goldman Sachs respectively to start their own distressed debt funds.

"We are probably getting someone coming to see us every week about raising a new debt fund," Michael Halford from law firm SJ Berwin said at a conference this month.

Data from EPFR Global shows flows into high-yield bond funds reached a net $4.4 billion (Dh16.14bn) between November and early February, at a time when most fund sectors saw outflows.

But plenty of players are warning that early adopters may be burnt, as continued forced selling by hedge funds could further deplete values, and defaults could still rise, threatening to deflate debt portfolios further. "The richest pickings follow the period in which default rates peak," said Chris Keen, a partner at hedge funds firm Culross Global Management. He said the firm was interested in distressed debt, but not just yet.

"Recovery rates are bound to be better when there's a market into which you can sell.

"While the numbers of distressed businesses are still rising it's more difficult to get people to take risk on the underlying assets."

Research by Edward Altman at New York University's Stern Business School confirms that the two best years for distressed investing – 1991 and 2003 – followed the peaking of high yield bond default rates.

With economists forecasting a lengthy, severe recession, and the bankruptcy cycle still in its early stages, funds that have bought assets at too high a price may struggle to make their targeted returns.

The market for distressed assets could continue to fall until the second quarter of 2010, said Graham Martin, co-leader of PWC's distressed debt group.

"In the UK there has been some nervousness as to when to enter the market, particularly with residential mortgage-backed securities (RMBS), and that's because of uncertainty as to whether real estate has bottomed," he said.

Investors worry about committing their own capital as they cannot obtain leverage from banks, and about the nature of government intervention.

"They're concerned the government might give mortgage holidays which would affect returns," he said.

The Mellon Recovery Fund, a dedicated distressed debt fund of Mellon Global Alternative Investments, lost 20 per cent in the last four months of 2008 with only 40 per cent exposure.

"The reason we are not buying... in the first quarter is because we see continued selling pressure due to the Madoff scandal," said Derek Stewart, the group's director.

"Our view is that this will be the biggest distressed debt cycle ever, and we are building that exposure, but very cautiously because prices are still falling," he said.

"A lot of investors came into the market too early in 2008 and got their fingers burned."

The distressed debt sub-strategy in the Credit Suisse/Tremont Hedge Fund Index – based on contributed data from 5,000 hedge funds globally – was down by 20.48 per cent in 2008.

High-yield is traditionally classed as distressed when the credit spread exceeds 10 per cent over government bonds.

Bank or leveraged loans have been regarded as distressed when they trade at prices representing less than 80 per cent of face value.

Now asset prices are falling across the board, pushing many companies to these levels whilst they are still far from default. This is tempting for investors.

Markets are still only a third of the way through the distressed cycle, said one distressed debt manager, who did not want to be named.

Respondents in a recent survey were divided as to whether to increase their allocation to distressed assets in 2009.

In the Debwire survey, 56 per cent said that they would ramp up their exposure, 31 per cent said they would not, and 13 per cent said the decision depended entirely on the movement of the market.

Corporate Bonds Are Next Bubble

Investment-grade corporate bonds are the next "ugly bubble" as default rates soar and more than half of issuers face multiple ratings cuts, said Bob Janjuah, a credit strategist at Royal Bank of Scotland Group.

Investors should be wary of buying investment-grade debt because defaults will "far exceed anything we have seen for 30-plus years," Janjuah wrote in a note to clients. "And how would the IG corporate credit market fare if it knew that well over 50 per cent of such issuers will see multiple ratings downgrades over the next 24 months?"

Companies have raised about $299 billion (Dh 1.1 trillion) selling bonds this year to investors lured by yields relative to government debt that are more than nine times levels on offer two years ago. Soaring issuance as defaults begin to rise from near-record lows have raised concerns a credit-market bubble is forming.

Standard & Poor's said last week that 75 companies with rated debt of $174.5bn are potential "fallen angels," meaning investment-grade companies that may be downgraded to junk status. That's the most in 18 years, according to S&P.

Junk, or speculative-grade, debt is rated below BBB- by S&P and Baa3 by Moody's Investors Service.

"Major issuers" with ratings of AAA or AA, the top two categories, may be "seriously at risk of multiple downgrades," Janjuah wrote.

Derivatives will reflect the surge in defaults, Janjuah wrote. Credit-default swaps on the Markit CDX North America Investment-Grade index of 125 companies may exceed 250 this year, he said, the highest since December and up from 220 in New York today. An increase indicates a worsening outlook for credit quality. Contracts on the Markit iTraxx Europe index, currently at 185.5, may rise to 200 or more, he said.

Investors are "deluded" in thinking that the current crisis is confined to the US and UK banking industries, according to Janjuah. "Europe is in at least as big a mess," he wrote. "There is simply a lag." The result will be that the euro will "take up the ugliest currency baton" from the pound, which took it over from
the dollar. Emerging markets will suffer most, and China will be a "major problem, not a major support," he said. "Folks looking to China as a solution don't get it."

RBS spokesman Steven Blaney in London wasn't immediately able to comment on the report. (John Glover)