Returns on distressed debt piquing investor interest

May 21, 2007 @ 9:24 am

By David Hoffman

PHILADELPHIA — Distressed debt can be risky, but that hasn’t stopped investors from turning to it in search of extra yield, industry observers say.

Several bond traders said they are getting more inquiries these days from clients who want to buy distressed-debt bonds.

It is easy to see why.

Lack of availability

Returns on distressed debt — junk bonds with a very high likelihood of default — were a strong 11.4% in the first quarter, outstripping all other asset classes, according to a recent report from Standard & Poor’s in New York. The S&P 500 stock index was up just 0.64% for the quarter.

But there isn’t a lot of distressed debt available for those investors who hope to jump on the bandwagon, said David Keisman, an analyst at Moody’s Investors Service in New York.

There is so much liquidity in the market right now that financing is easy to come by, he said.

Companies that normally would have found themselves in default have been able to refinance their debt, Mr. Keisman added.

But are these “rescues” permanent or are defaults merely being pushed off for a later date? That is a distinction Mr. Keisman said is impossible to determine until it is too late.

“No one is forecasting much of a default rate in 2007,” he said.

For example, S&P predicts that junk bond defaults will rise to 2.3% by the end of the year, from about 1.44% now, and reach 2.5% by the first quarter of 2008.

The long-term average junk bond default rate is more than 4%, according to Diane Vazza, head of global fixed-income research

at S&P.

Financial advisers, however, are still concerned.

Investors who think that distressed debt is a good investment are doing nothing but “chasing the pot of gold at the end of the rainbow,” said Harold Evensky, president of Coral Gables, Fla.-based Evensky & Katz Wealth Management.

“That’s not investing; that’s gambling,” he said.

Some high-yield-mutual-fund managers may be tempted to dip into distressed debt to improve their returns, but that would be a mistake, said Stephen Gorman, president of Gorman Financial Management Inc. in Hingham, Mass.

“I tend to stay with funds that are more credit conscious, that are not chasing the highest yield,” he said.

Single approach

That is the same approach taken by Eric G. Takaha, a senior vice president and director of corporates/ high yield at Franklin Templeton Investments in San Mateo, Calif.

“We’re not going to reach for yield,” said Mr. Takaha, manager of the Franklin Strategic Income Fund and the Franklin High Income Fund.

But he said he isn’t willing to tar the entire distressed-debt market with the same brush. Mr. Takaha said that he looks at all investments — including distressed debt — on a case-by-case basis.

That includes something relatively new and disturbing to some industry watchers: toggle bonds, which give the issuer the option of paying interest with more bonds.

There have been 10 sales of toggle bonds this year, totaling $5.14 billion — a record, according to S&P.

Because the bond sales have been so recent, Mr. Takaha said, he couldn’t say if his funds have been purchasers without compromising his portfolios, adding that there is nothing inherently wrong with toggle bonds.

The effect of toggle bonds, as well as some of the rescue financing, however, will be to push off junk bond defaults to a later date, said Martin Fridson, chief executive of FridsonVision LLC, a New York high-yield research firm.

“In the end, [default] recoveries are likely to suffer,” he said.

Of course, when defaults will rise, or by how much, is anyone’s guess, Mr. Fridson said.

The predictions by S&P that the junk bond default rate will rise to 2.3% by the end of the year seem reasonable, he said.

Even an increase to that level, however, could spell trouble for bond buyers, Ms. Vazza said.

“You’ll be hurt if you’re holding [junk] bonds,” she said.

Junk bonds — and distressed debt, in particular — will continue to win fans, because it is hard to predict what the catalyst might be for a rise in defaults, said Rick Fulmer, a Denver-based vice president and bond trader with D.A. Davidson & Co. of Great Falls, Mont.

Because spreads between high-yield bonds and U.S. Treasuries are much tighter than normal, investors have to take on more risk for less reward.

But the economy still is strong, and companies still are able to pay off their debt, Mr. Fulmer said.

The confusion has forced Greg Hermanski, co-manager of the Osterweis Strategic Income Fund, to cut back the junk bond holdings of the fund, which is advised by Osterweis Capital Management of San Francisco.

Others can relate to his dilemma.

“[High-yield bonds are] a small part of our bond portfolio, not a major part,” said Karen Altfest, a principal in L.J. Altfest & Co. Inc. of New York.

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