THE credit crisis and economic slowdown have sunk billions of dollars of debt into distressed status — deep in the junk-bond pile. Money managers have traditionally profited in such markets by buying debt on the cheap.
Individual investors can get into the game indirectly, through a small number of mutual funds, including BlackRock High Yield, Mutual Recovery and Northeast Investors Trust, which hold some distressed debt.
“Right now, we think there is going to be tremendous opportunity over the next 12 to 18 months,” said James Keenan, manager of BlackRock High Yield, which has returned 0.41 percent in 2008 and 7.15 percent, annualized, over the last three years, according to Morningstar. (All figures are through Thursday.)
Mr. Keenan foresees raising the fund’s current investment in distressed debt to 10 to 15 percent of assets, from the current 2 to 3 percent, as opportunities arise.
Distressed debt is often defined as the obligations of companies in default or perilously close to it. The term may also be used for debt paying a very high yield — 10 percentage points more than 10-year Treasuries.
Investing in such debt is risky, but handsome profits can be made by converting it into equity ownership as restructured companies leave bankruptcy.
The sharp rise in interest rates on lower-rated debt issues in recent months probably presages a rising tide of defaults, said Kenneth Emery, director of default research at the Moody’s Corporation.
“Historically, there’s a tight correlation between high-yield spreads and default rates,” Mr. Emery said. Already, the global pool of distressed bonds and bank loans is approaching $600 billion, he said.
Little cash has actually been drawn down to buy distressed debt thus far. “There have been a lot of funds raised,” said Michael Embler, chief investment officer for the Mutual Series funds of Franklin Templeton. “Most of the money has not been deployed.”
Oaktree Capital Management, based in Los Angeles, is a longtime investor in distressed debt. The firm has unspecified billions invested in such debt, said Howard S. Marks, its chairman, with $10 billion more ready to be deployed.
The question for Mr. Marks and others is when to start buying in earnest. Early buyers risk “catching a falling knife,” in market parlance, if prices keep tumbling. But late buyers risk losing out on the best deals and the best returns. “We think we have to catch a falling knife,” Mr. Marks said.
Other deep-pocketed buyers seem to be coming to the same conclusion. For example, the Blackstone Group, the big private equity group, has been finding good investments in distressed debt, Stephen A. Schwarzman, the chairman and chief executive, said in a recent conference call.
At Mutual, Mr. Embler is waiting for some of the debt that financed buyouts in the last year to tumble into distressed status.
“There was a tremendous amount of leverage in those buyouts,” he said. “Some of them will hit the wall.”
Just nine months ago, Mutual Recovery held virtually no distressed debt, but with recent purchases of leveraged-buyout-related bank loans, it now has “5 to 10 percent” of its portfolio in the lowest-rated obligations, he said. “We do think there will be more opportunities in the next 6 to 12 months,” he added.
The fund is down 4.31 percent this year and has returned 6.33 percent, annualized, over the last three years.
ALSO prepared to buy, but not convinced that prices have bottomed, is Bruce H. Monrad, who manages the $1.5 billion Northeast Investors Trust fund with his father, Ernest E. Monrad. The fund is up 0.14 percent this year and has returned 5.59 percent, annualized, over the last three years.
“We’re still in the very early innings,” he said. “We’re probably going to see 30 percent of the total junk bond market default over the next five years. And yet fewer than 30 percent of junk bond issues are selling at distressed prices. There may still be a lot of overpriced junk.”
The Northeast fund holds debt from one issuer — the Trump casino empire — that produced a big payday in the past. After Trump Hotels and Casino Resorts filed for bankruptcy in 2004, Northeast received a package of stock and bonds in the restructured company, Trump Entertainment Resorts. Northeast sold the stock but still holds some bonds, whose current yield is roughly 14 percent.
In terms of the broader credit market, Mr. Marks of Oaktree Capital said he saw a possible silver lining in the current situation, at least for investors in distressed debt.
“This could be the biggest credit crisis of our lives,” he said. “And if it is, that argues for higher returns.”
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