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Hedge funds avoiding distressed debt... examples of junk bond yields

Andrew Willis of The Globe & Mail mentions that hedge funds have, so far, been avoiding the distressed debt market:

In a sign that the smart money remains nervous about the state of credit markets, hedge funds are shying away from involvement in distressed debt.

In the past, hedge funds have been major players in the secondary market for loans gone bad, and the junkiest of junk bonds. Distressed debt has traditionally provided solid returns to sophisticated, specialized funds.

But a recent industry survey by Thomson Reuters HedgeWorld, picked up by TD Waterhouse, showed just 36 per cent of hedge fund managers held distressed debt investments, “down from nearly half of all respondents in 2007 when the opportunities on the market were far less lucrative.”

The hedge funds are steering clear despite unprecedented opportunities to put their money to work in credit markets. TD Waterhouse cited a Merrill Lynch report that showed “more than 70 per cent of the high-yield debt market is currently trading at distressed levels,” which is 1,000 basis points over U.S. government Treasuries.



It's truly remarkable when you step back and think about this: nearly 50% of the hedge funds owned distressed debt near the peak in 2007; yet less than 36% are willing to own it now, when prices are far more attractive. Buy high, sell low, anyone? ;) Does anyone still believe in efficient markets?

The question in my mind is whether the funds, which tend to be considered "smart money," although that title might be stripped the way things are going ;), are being prudent in avoiding the distressed debt; or whether they are simply avoiding it due to liquidity problems.

The quoted story refers to distressed debt but a slightly higher level is so-called junk bonds. How attractive are they? The following is a chart from bigcharts.com of a junk bond ETF (symbol: JNK):



The ETF started collapsing just before Lehman and Washington Mutual imploded but has rallied strongly in the last two months. But it seems to be weakening of late.

As an example of the huge yields, consider the following junk bonds of Sears Roebuck Acceptance Corporation and New York Times (source: FINRA):

(following charts plot yield)

SEARS ROEBUCK ACCEP CORP INTER NOTE 7.5% due 01/15/2013



SEARS ROEBUCK ACCEP CORP NOTE 7% due 06/01/2032




NEW YORK TIMES NOTE 5% due 03/15/2015



Many of these are illiquid but if you have access to it, it shows what is available in the distressed area for risky companies. Similar to the junk bond ETF chart above, the yields started spiking in October to very high levels. Sears Roebuck Acceptance Corp bonds have gone from a yield of around 10% to as much as 30% (this is just raw yield; since they are trading way below par value, yield-to-maturity is more like 50% on some of them.)

The default risk of the distressed firms have gone up significantly (especially if you believe the recession is going to be quite bad and that we may face mild deflation--deflation is lethal for debtors.) Nevertheless, if one can do their homework properly, bondholders may end up with ownership of the company if it defaults. You may not get face value but most of these bonds are trading at $0.50 per dollar or less.

Having said all this, the problem is that the bond markets are not friendly towards small investors. You generally need lots of money--my impression is that you need minimum investments of at least $20,000--for you to have access to the bonds or at least buy them at reasonable prices. It may also be impossible to get access to some of these illiquid bonds regardless of how much money you have.

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