Distressed Debt Is the Place to Be

Asset Managers, After Sitting on the Sidelines, Say They Are Ready to Buy By LIZ RAPPAPORT After years of gathering cash and waiting for the credit cycle to turn, investors who buy the debt of the most troubled U.S. companies are finally putting their treasure chests to work. Two-thirds of investors interviewed for a study say they plan to raise more money and increase their investments in distressed debt this year. One-third say now, or the first quarter, is the right time to buy, and more than half are expecting it to pay off smartly, projecting 20% returns or more for the year. The survey covered hundreds of asset managers, including those at hedge funds and bank proprietary trading desks. It was published by the law firm Bingham McCutchen LLP, FTI Consulting, Macquarie Capital (USA) Inc. and Debtwire. The investors say waiting could mean missing the market's bottom as President Barack Obama's stimulus plan, which could cause the junk-bond and loan markets to rally, is still being hammered out in Washington. (Some fund managers are also dipping toes into cheap mortgage-backed securities -- see related article) Most respondents in the study believe that it will continue to be difficult for companies to borrow cash to refinance their debt and get loans they need to emerge from bankruptcy amid the worst recession since the 1930s. With that in mind, several say they are most interested in buying senior-secured loans from troubled companies, aiming to possibly turn them into ownership stakes. Their priority is investing in securities that are first among debtors' claims to be paid out in a bankruptcy. Most investors who responded say they believe the current economic downturn will continue for at least a year, and several believe recovery won't come for two years. In terms of sectors, the favored areas of investment are financial-services and auto companies, both industries that have obtained substantial aid from the U.S. government. The loans tied to auto maker Chrysler's leveraged buyout by Cerberus Capital Management in 2007, were recently trading as low as 23 cents on the dollar -- loans some investors argue will pay out even if the company is liquidated. Ford's loans trade at about 34 cents on the dollar and General Motors' at about 43 cents. The surge in distressed investing comes as corporate defaults are on the rise, and prospects for more are growing increasingly dire by the day. In the first three weeks of the year, 14 U.S. companies filed for Chapter 11 bankruptcy protection, according to credit ratings company Standard & Poor's. Respondents to the survey expect that by the end of the year 9% of junk-rated debt will default. S&P expects that a record-setting 13.9% of the junk-rated bond market will be unable to pay its debt by the end of the year, while Moody's Investors Service says junk defaults will rise to 12%. In the study, investors say they are using less borrowed money, or leverage, to invest in loans and bonds, both because it is more difficult to get and less necessary with prices at such low levels. The investors also report that they are less likely to use credit default swaps to hedge their investments. The reason is concerns about counterparty risk, where participants on the other side of a CDS contract hit financial problems. At the start of the year, money managers put their first batch of distressed-oriented cash to work, pushing up prices and thus narrowing the spreads -- the gaps between junk-bond yields relative to risk-free Treasury bonds -- by four percentage points in a few weeks. These spreads had reached historically wide levels in December 2008, signaling the weakest companies must pay more than 20% to borrow, according to Merrill Lynch research. Now, more than 70% of the junk market is trading at distressed levels. That means more than 10 percentage points higher than Treasurys. The average junk bond yields about 17 points over Treasurys. The average price of a junk-rated leveraged loan has also gone up from an average of about 64 cents on the dollar to more than 70 cents in the past two months, according to S&P. Write to Liz Rappaport at liz.rappaport@wsj.com