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Debt Worm Turns for a Day

Liz Rappaport

As quickly as hedge funds can be the markets' foil, they can come to its rescue. Or, so investors seemed to think Monday.

It was the collapse of two subprime-focused Bear Stearns(BSC Quote) hedge funds in June and the sum total of their losses announced earlier in July that really sent the credit markets swerving off their rails.

But the credit markets and the stock market were able to bounce Monday mostly on news that hedge funds, among others, are bottom-fishing for opportunities.

The Dow Jones Industrial Average gained back 0.7%, or 92.84 points to close at 13,358.31, while the S&P 500 added 1% to close at 1473.91 and the Nasdaq Composite finished the day up 0.8% at 2583.28.

After widening out by another 60 basis points in early trading Monday to kiss a recent risk premium high of 602 basis points, the high-yield bond market, as measured by its related CDX derivatives index, snapped back on news that hedge fund Citadel Investment Group is buying the soured credit holdings of hedge fund Sowood Capital, which manages about $3 billion. The CDX index closed Monday at a risk premium of around 500 basis points.

Sowood has investments in stocks, bonds and convertible bonds; Citadel is buying the credit portfolio in a transaction that The Wall Street Journal reported is most likely "worth hundreds of millions of dollars."

"There is still a lot more to recover," says Brian Hessel, managing partner at Stonegate Capital. But, Citadel's "vote of confidence" is meaningful in that it takes some of the potential marked-down supply out of the equation, he adds.

"People are circling the wagons looking for opportunities, and the market has sold off to levels where it makes sense to redeploy capital again," Hessel says, adding there's plenty of additional money on the sidelines.

Christopher Vincent, head of fixed income at William Blair & Co., says his firm was "nibbling" Friday in the high-grade credit markets at bonds in the battered financial and industrials space.

Goldman Sachs(GS Quote), like Citadel, may be nibbling out there in the credit markets as well. The firm increased the size of a corporate credit fund that was originally intended to be $12 billion to $20 billion, according to reports.

Indeed, the Goldman fund could be one of many hedge funds out there willing to buy some of the banks' loans and bridge loans at bargain basement prices.

It's no secret that with risk premiums running for so long at such low levels, many hedge funds have had trouble meeting their performance targets and have chased yield in dangerous places, like subprime mortgages.

Goldman was on a roll Monday as news also came out that the investment bank's private-equity unit will expand its investment in middle-market companies between $500 million and $2 billion through a unit called GS Direct.

Goldman Sachs was up 1.6% Monday while the broad Amex Securities Broker Dealer Index gained 1.3%.

The bottom-fishing wasn't limited to the credit markets. Several stock market strategists came out with recommendations to buy stocks after last week's rout. Goldman published a report identifying several buyout targets trading below their bid prices on fears that buyout deals will not succeed.

Bank of America's chief equities strategist Thomas McManus increased his recommended equity allocation by 5% to 60%, and cut his recommended allocation in Treasury bonds by 5% to 15%. He says a surge of put-buying amid broad market fear could instigate a short-covering rally.

On Friday, McManus forecast a short-term bounce, writing: "Some sectors that have been pummeled recently are now more attractive, in our view; we are looking at increasing our banks and utilities exposure -- two areas where our model portfolio has had zero weighting."

Also, Citigroup's Tobias Levkovich recommends buying diversified financials, including Merrill Lynch(MER Quote), Charles Schwab(SCHW Quote), Goldman, JPMorgan Chase(JPM Quote), and Bank of America(BAC Quote). "Valuation is attractive," he writes. "We believe fear levels have gone too far."

Schwab gained 2.7%, while JPMorgan gained 1.2%, and Bank of America added 0.6%.

In addition to dip-buying, an unusual stream of relatively decent news trickled out of the credit markets Monday, including fewer losses than in the first quarter from General Motors'(GM Quote) mortgage financing unit ResCap. GM's financing unit, GMAC, overall reported a 63% decline in second-quarter profits. General Motors gained 4% Monday. Ford (F Quote) added 6.2%.

Investors had gotten used to mortgage-related downgrades out of the credit ratings agencies, but Monday Standard & Poor's surprised the market with something focused on the positive.

S&P increased Morgan Stanley's(MS Quote) credit rating and adjusted its outlook to stable from positive. The ratings agency noted that the investment bank stands out as "especially well-positioned to withstand market volatility compared to industry peers."

S&P also noted that it "believes its exposure to the woes of the U.S. subprime mortgage market and to problematic leveraged corporate underwritings is manageable." And, S&P says the firm "should be able to maintain satisfactory earnings even if market conditions are considerably more challenging."

S&P's analysis could be the start of the next leg of this credit market correction, if all else remains status quo.

Market participants understand what a collateralized debt obligation is, what leveraged loans are and how private equity was able to stick loans with investment banks' balance sheets. With more than a weekend's worth of mulling, the analysis will continue to turn more from panic-stricken "whys" and "how comes," to questions of "who's worst off" and how will the markets resolve the credit markets' recent turmoil?

The key is all else remaining status quo: Tuesday brings the next read on the health of the consumer with the personal income and consumption data for June along with the Federal Reserve's preferred inflation measure, the core personal consumption expenditures index.

Analysts predict core inflation rose a modest 0.2% in June while incomes are expected to have gained 0.5%, but spending is expected to be weaker. Analysts expect it edged up only 0.1% in the month, after a 0.5% jump in May.