Distressed debt investing

Distressed debt is shaping up to be the hot investment topic for 2009. Hedge funds announce mammoth allocations to distressed debt almost weekly; the big pension funds are signing up; while the endowment fund for America's second richest university, Yale, has announced it is investing in distressed debt to rebuild the value of its portfolio which has been battered by the global financial turmoil.

There are a number of ways for individual investors who have never seriously considered distressed debt as an opportunity to "get their toes in the water."

UK-based Neil Liversidge, managing director of independent family-owned advisors West Riding Personal Financial Solutions, says distressed debt investing isn't just the latest fad for investors. It has a long and distinguished pedigree, he says, and most investors should consider the strategy very seriously.

"Academician W Braddock Hickman published a study in the 1950s," Liversidge said. "After studying US corporate bond performance from 1900–43 he proved that the returns of a large diversified portfolio of high yield bonds held over a long period more than outweighed the additional risk that such bonds presented over investment grade paper." A later study updated and confirmed the findings for the period 1944 to 1965.

Warren Buffett's financial guru Benjamin Graham, meanwhile, widely described as the father of value investing, presented the same conclusion in his 1973 book, "The Intelligent Investor."

According to Liversidge the safest and easiest way to get started with distressed debt investing is to buy shares in a junk bond fund. Despite the fact that their names don't include the words "distressed debt," most junk bond funds – almost universally identified by the slightly more dignified name "high yield" – are turning into distressed debt funds, without telling anybody about it.

Traditionally, a junk bond or high yield bond fund is one that invests in bonds given a  below-investment-grade rating by one of the bond rating agencies. The "junk" refers to the rating and nothing else. Until recently, distressed debt was an entirely different thing.

Distressed debt is defined as debt yielding 1,000 basis points or more above the yield of Treasury securities of comparable duration. As the year 2009 opened for business, three-year Treasuries were yielding just under 1%, the five-year note was paying about 1.5% and 10-year Treasury debt was paying just slightly more than 2%. Thus, a five-year corporate bond yielding 11.5% or higher in the first week of this year fell within the technical definition of distressed debt.

In recent months, Liversidge said, corporate debt issued by solvent operating companies has been routinely yielding 12–18%. Thus, junk bonds are increasingly paying high enough yields to classify as distressed debt – based solely upon their historically high yields compared to Treasury securities.

Although the aversion to debt that has swept through the markets as a result of the global financial crisis has driven up yields for top-rated investment grade bonds, for the moment, junk bond funds are a fine place to start.  

Liversidge said his preferred junk bond funds at the moment are the Threadneedle High Yield Bond, Baillie Gifford High Yield Bond Fund and Cazenove Strategic Bond. Two others worth looking at are Artemis High Income and New Star High Yield, he said. All are widely available in the UK.

In the US, the investment information service Morningstar recommends the Eaton Vance Income Fund of Boston, Fidelity High Income, PIMCO High Yield D, T Rowe Price High-Yield and Vanguard High-Yield.*

Another approach is to invest in a fund that focuses specifically on corporate debt, such as the PIMCO Floating Rate Income Fund, which primarily holds high-yield floating rate debt instruments. This January, the fund was generating a 17.98% dividend yield.

Its sister fund, the PIMCO Floating Rate Strategy Fund follows an investing style that turns out to be pretty much the same and was pumping out a 19.23% dividend yield in January.

But there's no shortage of corporate bond funds showing spectacular yields. At about the same time this year that the PIMCO funds were announcing their stellar yields, the Nicholas Applegate Convertible & Income Fund was reporting a 27.23% dividend yield while its sister fund Nicholas Applegate Convertible & Income Fund II was delivering a dividend yield of 27.67%.

Distressed debt is showing up in other unlikely places as well. For example, in the exchange traded fund (ETF) iShares Barclays Aggregate Bond Fund. This ETF is described by its fund manager as an intermediate investment grade bond fund.  It was one of the top five performing ETFs for the year. It did better than all other corporate bond ETFs last year and came in just below three Treasury bond ETFs and just above another Treasury ETF and a gold ETF.

The iShares Barclays Aggregate Bond Fund (AGG) reported one-year performance of 7% while in the comparable period the S&P 500 turned in a -39% yield. How did they do it? They spiced up the yields with distressed debt.

AGG held substantial positions in carefully selected securitized mortgage bonds, as well as some very high yielding corporate bonds, and all of them held their investment grade ratings through the market meltdown of 2008.

It also has a big stake in a commercial mortgage backed securities (CMBS) issue yielding 11.83%. Barclays isn't the only investor to discover the magic of CMBS, which have been posting truly spectacular market yields, despite the horrible reputation of mortgage-backed bonds.

The crucial distinction is that CMBS are linked to commercial mortgages, rather than residential mortgages. Over the past five years, underwriting standards for commercial mortgages, which are used to finance warehouses, industrial buildings, stores, office buildings and apartment properties, have been much more stringent than those for residential mortgages.

Also, CMBS are structured in a way that protects investors from losses from anything less than enormous rates of default. As a result, about 80% of CMBS bonds on the market have kept their original Triple A ratings.

The market prices were pounded because the word "mortgage" frightened bond buyers. But the owners of most of those commercial buildings continued making their mortgage payments.

Darrell Wheeler, managing director and global head of CMBS Strategy & Analysis at Citi Global Markets, said these bonds are turning out 14–16% yields, which he describes as "outrageous." He said he'd rather hold CMBS as investments than Treasuries.

As with all other types of bonds, the way these bonds are marketed makes it impractical for individual investors to buy them directly. For most people, bond investing only make economic sense when it is done through some kind of a fund.

Based upon the talk heard in the world's major financial centers, there may be dozens of publicly traded distressed debt and CMBS funds on the market by spring. But for now, you have to hunt for them in the portfolios of funds and ETFs with names that wouldn't give you a clue that they hold significant amounts of distressed debt or CMBS.

An indirect way to invest in CMBS is to buy shares in regional banks and real estate investment trusts (REITs) that hold substantial positions in CMBS. But, again, you have to plow through their financial reports to find out just what they're holding in their portfolios.

Regardless of how you look at it, says Bill Cara, president and chief trader of Cara Trading Advisors, Nassau, Bahamas, and author of the recent book, "Lessons From The Trader Wizard," now is an ideal time to buy the debt of financially sound, operating companies with investment grade credit ratings.

"Buying high-yield distressed debt makes sense at this point because as the economy improves, and with it the corporate prospects for refinancing at lower yields, the prices will rise from great depths," he said. "But this is a market for professionals." It should be noted that not everybody agrees that buying distressed debt is the best way to profit from today's market turmoil.

Ira J Perlmuter, managing director of T5 Equity Partners in New Jersey, buys distressed operating companies in bankruptcy, or on the verge of slipping into bankruptcy, for the family that owns The Mall of the USA.

"What I do is a little different," he said. "I buy whole companies that are in bankruptcy or some form of distress." Perlmuter said he buys basically good companies with sound business plans that got into trouble because of some kind of a problem, often the result of a lawsuit or taking on too much debt.

"We get as close to the assets as we can," Perlmuter said. "It's not a matter of owning some paper that gives us the right to collect something. We have the hard assets, machinery, buildings, land, the accounts receivable, everything."

He said taking over a company in bankruptcy and returning it to profitability is a lot more demanding and requires much more management expertise than buying debt. But there is some compensation for taking on these additional burdens. "I've done over $8 billion worth of bankruptcy and restructuring deals," Perlmuter concludes. "Last year we had a notional return of over 1,000%."

* Not being a resident of the UK or the US isn't really a problem. Most brokers with offices in the major offshore financial centers can get you shares in just about any major fund domiciled anywhere in the world.