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Reproduced from Preqin Pro; Chart: Axios Visuals

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.

Go deeper

Kate Marino, author of Markets
Aug 4, 2021 - Economy & Business

Debt investors retreat from funding dirty energy

Illustration: Sarah Grillo/Axios

Banks are coming under fire from all sides for their role in funding fossil fuel companies, even though most have pledged to pull back over the coming decades.

What's happening: Despite pressure from activists, shareholders and Democratic politicians to finally divest from carbon-spewing businesses as the planet warms, the biggest American banks are still energetically backing dirty energy.

Judge nixes Gulf of Mexico oil leases in climate-focused ruling

Tug boats prepare to tow the semi-submersible drilling platform Noble Danny Adkins through the Port Aransas Channel into the Gulf of Mexico on December 12, 2020 in Port Aransas, Texas. Photo: Tom Pennington/Getty Images

A federal judge on Thursday canceled the Biden administration's late 2021 sale of new oil-and-gas drilling leases in the Gulf of Mexico.

Why it matters: The ruling that the greenhouse gas emissions analysis by the Interior's Bureau of Ocean Energy Management (BOEM) was insufficient is a win for green groups that challenged the decision, as they seek to curb fossil fuel production.

45 million Americans under winter storm watches near New England

Computer model projection showing the winds moving around the powerful East Coast storm on Saturday Jan. 29, 2022. Credit: https://earth.nullschool.net

Nearly 45 million Americans are under winter weather alerts and warnings from North Carolina to northeastern Maine Thursday night, as a major winter storm threatens the region.

Why it matters: It is predicted to be the biggest blizzard since 2018 to strike the Northeast with more than 2 feet of snow possible in parts of eastern Massachusetts, according to the National Weather Service.

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