Distressed Debt Proves Toxic Like 2008 as Defaults Fuel Losses

  • Strategy set for worst year since Lehman Brothers collapsed
  • Failures in Asia contributed as Kaisa reneged, Berau defaulted

Global hedge funds betting on distressed debt are suffering their worst year since 2008 as corporate defaults in emerging markets such as Asia spiked higher and the fifth year of a commodity slump fueled losses. Things might only get worse.

Funds using distressed-debt strategies lost 4.5 percent this year through November, set for the first annual decline since the global financial crisis, according to Eurekahedge Pte. Some investors are predicting more losses after a market rout forced Third Avenue Management LLC to liquidate a mutual fund. Amid growing stress in the credit market, the Federal Reserve on Wednesday raised interest rates for the first time in almost a decade.

“There may be many more shoes to fall,” said Putri Pascualy, a portfolio manager at Irvine, California-based Pacific Alternative Asset Management Co., which invests in hedge funds. “There are some buying opportunities in our pockets, but we aren’t in a 2009 type of environment where we are ‘backing up the truck.’”

In Asia, investors rank liquidity shortage atop their concerns after a 9 percent drop in trading of credit products this year, according to a survey published on Dec. 14 by Stamford, Connecticut-based Greenwich Associates. Among Asian issuers, China produced landmark debt blowups this year, with Kaisa Group Holdings Ltd. reneging on payments and China Shanshui Cement Group Ltd. defaulting on notes.

Exiting Business

Eight distressed-debt funds exited the business this year versus seven in 2014, bringing the total to 93 over the past five years, according to Eurekahedge. As prices for oil, iron ore, coal and copper fell, Anglo-American Plc and Vedanta Resources sold or closed mines. Oil and energy producers are pushing global bond defaults to a six-year high. Indonesian coal mining company PT Berau Coal Energy defaulted on a $450 million bonds in August.

“Managers invested in distressed corporate debt have taken the main hit this year, as their exposure to corporate debt in the broad commodity sector has under-performed,” said Mohammad Hassan, a Singapore-based senior analyst at Eurekahedge. “Next year could be interesting. If in particular commodity prices surprise on the upside, then managers who have bought in at the current bargain prices could post good returns.”

Asian Defaults

Some distressed debt specialists, such as Oaktree Capital Group LLC, are expecting 2016 to yield better opportunities, as a slowdown in China spurs a new cycle of troubled loans. The world’s biggest distressed-debt investor, with 26 percent of its $100 billion assets dedicated to the strategy, is seeing the most opportunities since Lehman Brothers Holdings Inc. collapsed, Co-Chairman Howard Marks said on Dec. 9.

“Post-Lehman there was too much to do and now there is again,” Marks said, referring to the financial crisis that followed the collapse of the investment bank in September 2008. “For the credit investor we have our first opportunities in several years."

Others said investors seeking bargains might have to wait. Paamco’s Pascualy said many managers seeking higher yields in a low-rate environment have crowded into similar themes and trades too early, such as buying securities in the coal industry.

“In the past, investors have been rewarded for buying the dip,” she said. “Unfortunately, this time it’s different.”

Issuer Defaults

Standard & Poor’s counted 103 issuer defaults this year through Dec. 10, the first time they have surpassed 100 since 2009 with oil and gas sector accounting for 26 percent of them. Among them, 32 offered distressed debt exchanges, 29 missed bond principal or coupon payments and 21 entered bankruptcy filings.

Credit hedge funds Mudrick Capital Management and Knighthead Capital Management extended losses for the year in November amid a rout in the junk-bond market, according to investor updates. Jason Mudrick’s Distressed Opportunity fund fell 19.7 percent this year through Dec. 4, after losing 3.6 percent in November. Knighthead, the $3.4 billion investment firm co-founded by Tom Wagner, dropped 0.8 percent in its main fund in November, bringing losses for the year to 9.4 percent.

“Emerging markets crisis is in full swing,” David Tawil, co-founder of New York-based Maglan Capital LP, whose distressed fund gained 14.85 percent in November and 8.35 percent this year, said in an interview. “Analysts can try to deny it by continuing to strip out energy, metals and mining from data and metrics. The spillover effect to other sectors is serious.”

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