Distressed Debt Investors Hover as Default Risk Soars

A looming recession and tightened credit markets are creating a perfect storm for distressed debt investors.

Against this backdrop, hedge funds and private-equity shops that invest in financially troubled companies have been raising record amounts of capital. Their hope is to buy debt on the cheap and profit from the fallout of the sloppy lending and hefty debt loads of the leveraged buyout boom.

Credit markets remain under significant pressure because of worries about the fate of bond insurers such as MBIA(MBI Quote - Cramer on MBI - Stock Picks) and Ambac(ABK Quote - Cramer on ABK - Stock Picks), which are struggling for capital because of rising losses.

Since the start of the year, credit spreads have been soaring on the CDX investment grade index, which tracks the price of credit default swaps on a basket of corporate bonds. The rising spreads suggest that investors selling protection are looking for higher returns because credit qualities among corporate bonds are getting worse.

The spread on the index has vaulted from 42 basis points in July to around 124 basis points this week, according to Markit.

These moves are being primarily driven by the worries over the bond insurers, says a trader at a major investment bank who specializes in credit default swaps on the CDX. "If there is a bailout, how big will it be? Is it one or the entire industry? Even if there is a bailout, there are still credit concerns," the trader says.

The spreads today are pricing in higher corporate defaults than the ratings agencies are predicting, the trader says.

Moody's expects global default rates on speculative-grade corporate bonds will hit 4.2% in 2008.

"If Moody's is right, the spreads are too wide on the index," the trader says.

Rising default rates are a godsend for distressed debt firms, who specialize in buying distressed or defaulted corporate debt on the cheap and profiting from an ultimate recovery of the corporation.

Distressed debt investors gathered in New York this week for the 2008 Leadership in the Distressed Markets conference, and these increasing defaults and the economy's slowdown were at the forefront of the discussion.

The consensus at the conference was that an official recession, as defined by at least two consecutive quarters of negative GDP growth, has either started already or will show up in the next quarter or two. Although GDP growth has yet to turn negative, the companies on the S&P 500 collectively had negative earnings growth in the fourth quarter, breaking a string of 17 quarters of double-digit earnings growth.

With business fundamentals deteriorating, large debt loads become ever more onerous.

Bruce Richards, CEO of distressed specialist Marathon Asset Management, which manages $10 billion, says 162 companies will either default or restructure in the next 12 months.

"Private equity was the problem," he told investors at the conference, pointing to the large amounts of debt placed on firms.

Homebuilders, in particular, are seen as becoming even more troubled over the next year.

"Homebuilding and related industries are currently going through some difficulties which are expected to get worse," says Mohsin Meghji, managing director with restructuring advisory firm Loughlin Meghji + Company.

Richards is particularly bearish on housing. He expects housing price declines to continue through 2009 and possibly not trough until 2010.

He believes it is too early to find distressed opportunities among homebuilders (meaning they have more pain to play out in their fundamentals). Instead, he says, Marathon is focusing on opportunities in loans and asset-based securities tied to the subprime industry.

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