The worse that junk debt appears to most of the investing world, the better it looks in the eyes of the biggest distressed-debt investors.
U.S. junk bond yields have surged almost two percentage points in just seven months, to an average of 8.1 percent, and firms including Oaktree, KKR and Avenue Capital are starting to see some value. Avenue Capital’s Marc Lasry called junk-rated energy debt a “once-in-a-lifetime opportunity” at a conference this week. While the broader high-yield bond market will likely decline further, Oaktree’s co-chairman, Bruce Karsh, said a few weeks ago the firm has started to see some companies “trading at levels that got us very busy in terms of looking at opportunities.”
KKR’s Scott Nuttall, who heads the firm’s global capital and asset-management group, said this week at a conference that recent volatility in leveraged credit had resulted in some attractive offers, especially in private and infrequently traded debt.
But just because they like the fat yields doesn’t mean that it’s a good time for individual investors to pile into exchange-traded funds or index-tracking mutual funds that focus on speculative-grade debt. In fact, these funds may continue to do badly, or even suffer bigger declines, even as behemoth distressed investors reap decent profits.
The reason is these multibillion-dollar firms have plenty of cash on hand that they can pile into speculative-grade companies. They can leave their money with these companies for years -- and perhaps even lend them more in a pinch --- until the debt matures, all the while receiving hefty coupon payments at a time when government bonds still pay historically low rates. Even some of these investors may end up suffering more losses than they expect when defaults start accelerating.
But generally, the more toxic the credit cycle, the better for these firms because a greater proportion of companies will be desperate for loans and willing to pay bigger fees for the privilege of borrowing. Also, big investors can buy debt at a significant discount when others get cold feet or need near-term cash and bail out.
There’s already a whiff of desperation in some parts of the credit market.
This week, banks led by Morgan Stanley offered investors a deep discount to buy debt backing Sycamore Partners’ acquisition of retailer Belk after struggling to attract interest in the loan. Investor push-back forced Bank of America and Morgan Stanley to shelve a debt package backing the year’s largest leveraged buyout, Bloomberg News reported.
This will ultimately lead to good times for distressed investors. For the average ETF or mutual fund investor, however, this is a treacherous time. The default rate is rising and may rise much more in the near future.
Indexes tend to be more heavily weighted toward the most indebted companies, and these funds have a higher proportion of their assets in more frequently traded bonds, which usually perform more poorly during deteriorating markets. This year, for example, the iBoxx U.S. Liquid High-Yield index has lost 2.2 percent, more than the 1.6 percent decline on the broader market tracked by Bank of America Merrill Lynch data.
The less-traded debt, which is the domain of a place like KKR or Avenue, may have a better chance of holding up in the long run. But just because some big firms are finding some gold doesn’t mean the rest of the pile is so great. And just because there’s a lot of garbage in the junk heap doesn’t mean there’s no treasure. It just takes a big shovel to find it, and it can take a long time.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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