Invest in Distressed Debt and Still Sleep at Night

Many of the smartest investors of our time have hinted that the best investment opportunity at this point in the credit cycle might be to invest in distressed debt that trades at pennies on the dollar. But how does the average investor do that?

Because I don't have the experience or time to look at individual debt securities (and keep up with each over time), I have purchased shares of the Highland Credit Strategy Fund (HCF - commentary - Trade Now). The yield is about 12% on the basis of the distribution announced in July. The shares trade at 19% discount to net asset value and about a 59% discount to the price at which the funds' securities were purchased by the fund (discount to par is likely around 66%).

• About two-thirds of the holdings are senior floating-rate bank loans. You can find latest schedule of holdings at the Securities and Exchange Commission's Web site. Because the bank debt is almost entirely floating-rate debt, any increase in rates will increase the yield of this fund without hurting net asset value (unlike a typical bond fund whose NAV will be hurt by rising rates).
• The yield should not go much lower, because the London inter-bank offered rate, or Libor, is at 0.60% and only going up from here.
• The senior banks notes are supposed to trade at par, yet the current senior loan portfolio (two-thirds of the fund) is essentially being valued by the market at 42 cents on the dollar. This indicates that a pretty big cushion for defaults and bankruptcies (which will increase) is already built in.

A significant percentage of the senior loans are for private-equity-backed deals, and that is a big red flag for most investors. Because the private-equity firms will realize 100% losses on their equity investments if these loans aren't paid off at par, you can bet the PE guys are working overtime to try and prevent these companies from defaulting. Yes, a great number of these deals will fail, but my bet is that the recovery is better than the imputed default rates, and the yield is nice while I wait.

The big risk in this fund is that many of the underlying credits won't be able to refinance when their loans come due (typically the loans have five-year terms), but again the smartest PE guys are "on it," and their careers depend on it. If you love junk, this fund is for you.

All in all, I believe the risk here is worth the return, especially if you believe that the worst is behind us. This idea comes from Bill Burnham of Inductive Capital, who is not only one of the smartest investors out there but one of the most conservative. If he owns this, I want to own it.

At the time of publication, Koh Goldstein was long HCF.

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Know what you own: A number of bond-related ETFs might be of interest to readers of this column, including the SPDR Barclays Short-Term Municipal Bond ETF (SHM - commentary - Trade Now), the SPDR Barclays Municipal Bond (TFI - commentary - Trade Now) ETF, the iShares Barclays 20+ Year Treasury Bond (TLT - commentary - Trade Now) ETF, the iShares Barclays 7-10 Year Treasury Bond (IEF - commentary - Trade Now) ETF, the iShares Barclays 1-3 Year Treasury Bond (SHY - commentary - Trade Now) ETF, the iShares Barclays 3-7 Year Treasury Bond (IEI - commentary - Trade Now) ETF and the iShares Barclays 10-20 Year Treasury Bond (TLH - commentary - Trade Now) ETF.

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Kristen Koh Goldstein started in the business in the early 1990s at First Boston Asset Management as a portfolio trader running market-neutral portfolios. After going through Credit Suisse First Boston's equity research training program, she returned to the buy side, managing the software investments for an internal fund at Goldman Sachs. She now manages a family fund which includes investments all along the liquidity spectrum. Koh Goldstein is also the CFO of an early-stage portfolio company of the fund called Home-Account, which enables her to keep her eyes on IT spending trends to generate investment ideas. She has an MBA from Harvard Business School and a bachelor's degree from Cornell.