Distressed hedge funds that raised record amounts of cash last year to invest in COVID-hit businesses are sitting on a mountain of cash and competing for crumbs to invest it in.
Why it matters: Government stimulus programs, and the Federal Reserve’s intervention in markets, caught many Wall Streeters by surprise last year with their magnitude. They effectively cut short the distress wave that these hedge funds have been waiting on for over a decade — leaving many now scrambling for what to do next.
How it works: Distressed funds, which mostly buy the loans and bonds of struggling companies at pennies on the dollar, hope to profit when the issuers default and can't pay their debt bills. Outside of industry-specific pockets like oil and gas or retail, this hasn't happened en mass since the financial crisis.
What they're saying: “In the short term, I worry about not having great things to buy,” Oaktree Capital Management's Howard Marks said at an event this week, Bloomberg reports.
By the numbers: Distressed funds prepped for a pandemic doomsday scenario by raising $46 billion in 2020, almost double the annual average of $24 billion over the prior nine years, according to Preqin.
- The typical places to put all that cash did not offer the opportunity investors thought they would, leaving funds sitting on $81 billion in dry powder as of September 2020.
- With nowhere to go, distressed funds returned negative 8% on average during 2020 through September, compared with an average annual return of 12% from 2001-2019, Preqin says.
There are few signs of this dynamic changing.
The portion of high yield bonds that trade at distressed levels is just 2.8%, from 35% a year ago. It's now at the lowest level since 2007, according to S&P Global Market Intelligence.
- The leveraged loan distress ratio is 2.04%, from 31% last March.
Default rates tell a similar story.
- Rolling 12-month loan defaults hit 2.6% in April, slipping below the historical average of 2.9%. That's down from its peak in September at 4.15%, according to S&P.
- The U.S. high yield bond default rate has come off its 2020 high point of 9.7%, and now sits at 7.7%, according to BofA Global Research.
What’s next: A hunt for new opportunity. Some funds are turning to more esoteric assets like vendor or insurance claims, or even returning cash to investors, Bloomberg reports.
- Many have stretched to non-distressed high yield bonds — where strong demand has pushed up prices of even the riskier, lower-rated bonds, says Gershon Distenfeld, co-head of fixed income at AllianceBernstein.
- The bubble-like demand has caused the high yield index to hover at record tight levels in the low-4% area.
What to watch: The Fed and a rate hike.
- “The Fed is a cycle killer,” says William Housey, senior fixed income portfolio manager at First Trust Advisors.
The bottom line: What is generally a good sign for the economy, is a distressed investor’s worst nightmare.