Stressing out over distressed debt

Though WorldCom’s recent meltdown may have singed the distressed-debt market, hedge fund managers insist it’s still a good time to be investing in below-investment-grade bonds.

With few exceptions they say they are continuing to allocate record-level assets to strategies that essentially bet on the ability of bankrupt companies to satisfy their creditors.

The investments are a strong indication that hedge fund managers are still betting on an economic rebound, which troubled companies are counting on to help rebuild their businesses.

Shoaib Khan, senior vice president of research at LJH Global Investments LLC, a Naples, Fla., hedge fund advisory firm overseeing $3 billion, says WorldCom left some hedge funds down as much as 8% for the month of June.

Through the first half of the year, distressed-debt hedge funds were up an average of 1.7%, according to The Hennessee Group LLC, a New York hedge fund consultant and investment adviser.

An analysis of 10 closed-end mutual funds that invest in high-yield bonds with some distressed-debt exposure shows that the average fund was down 8.2% for the month of June and 8.3% year-to-date through last Wednesday, according to New York mutual fund tracker Lipper Inc.

As Mr. Khan points out, there was no way to predict that a global telecommunications giant such as WorldCom of Clinton, Miss., would be embroiled in what may be one of the biggest accounting frauds in history. Last month, the company disclosed that it had misstated $3.8 billion in expenses as capital expenditures in an effort to appear more profitable.

When Bernard Ebbers resigned as CEO in late April, WorldCom’s shorter bonds, scheduled to expire between 2003 and 2005, were trading at between 75 and 85 cents on the dollar. Immediately after the fraud announcement was made in June, they started trading at between 10 and 18 cents on the dollar.

Currently, those same shorter-term bonds are trading at between 14 and 16 cents. So hedge fund investors who sought bargains after the resignation, believing in the company’s numbers, got burned. But if they bought in after the announcement, they actually may have made money.

Mr. Khan, who refers to the performance of distressed strategies in June as a “hiccup,” is representative of the kind of optimism that fund of hedge fund managers have in distressed-debt strategies.

“The opportunity for distressed has been quite attractive,” he says. “Funds of funds have been increasing their allocations in this area for about a year, and I don’t think that should change.”

The bottom line is, even as accounting fraud becomes the strategy’s newest wild-card risk, most hedge fund professionals think solid arguments can be made in favor of distressed-debt investing. And those responsible for building hedge fund portfolios say now is not the time to pull back the allocations.

Mark Spangler, president of Spangler Financial Group Inc. in Seattle, has increased his allocation to distressed debt to about 20%, up from 15% a year ago.

“When there’s blood on the street, these [distressed-debt strategies] tend to do well,” says Mr. Spangler, who oversees $100 million for clients and operates a fund of funds.

“There’s going to be a lot of opportunity in distressed debt. I’d say the current run [for the strategies] has at least 18 months to two years left.”

Hennessee’s research shows that assets in such strategies doubled in 2001 to $17 billion. Hennessee’s distressed-debt index was up 9.63% for the year.

“There has been a lot of money moving into distressed debt because it’s seen as an easy way to make money,” says Mr. Spangler. “Of course, WorldCom is an example of how that doesn’t always work.”

But not everyone is sold on the idea of loading up on distressed-debt strategies. Hennessee managing principal Charles Gradante says that even if you could take accounting fraud out of the equation, distressed debt would not be a wise allocation at this time.

“Last year the feeling was that the economy would turn around, and a lot of distressed debt would be refinanced in the credit market.”

Mr. Gradante says that Hennessee, which oversees $1 billion in client assets, steered clear of distressed debt last year and continues to avoid the strategy.

“We think the funds of funds made a mistake by getting [into distressed debt] too early and with too much money,” he says. “In the beginning of 2001, everybody was speculating using the old rules, such as: When the Fed cuts interest rates, the economy turns around.”

He says that most investors were looking for a repeat of 1991, when the economy pulled out of a recession, and distressed strategies re- turned an average of nearly 35%.

At that time, there were a number of large companies with good business models and bad balance sheets that could be fixed through refinanced debt.

Many of the companies in today’s distressed-debt market, Mr. Gradante says, have both bad business models and bad balance sheets, and may not survive.

“What the fund-of-funds managers missed is that this is not a typical bear market,” Mr. Gradante adds. “We are in a deflationary market, which means the declining interest rates may not turn the economy around.”

Mr. Gradante thinks the distressed market “might be a good buy around the end of the third quarter.”

But before Hennessee starts moving in that direction, he says, there will need to be a decline in both bankruptcies and bond-rating downgrades, and some improved earnings reports.

General downtrend

Hedge funds employing distressed-debt strategies aren’t the only ones struggling to stay in the black this year, but the strategy stands out as a disappointment in light of such a heavy push in that direction over the past 18 months.

According to Hennessee, 17 out of 23 hedge-fund-strategy indexes were negative for the month of June. Over the first half, however, only 11 strategies were in the red.

The health-care and biotech index was the biggest disappointment, down 13.4%; the telecom and media index fell 12.8%.

The best-performing hedge fund strategies in the first half, according to Hennessee, were the short-biased index, up 13.5%, and the financial equities index, up 8%.