John Dizard: junk veterans will trump the newbies

For the past three years or so, seasoned investors in high yield and distress securities have been losing ground to the newbies. If you had survived the recessions in the early 1980s and 90s, then you couldn’t see the value in the junk paper given steroid injections by the new hedge funds and prop-desk traders. So you didn’t buy it.

Then it rose in price because there really were a lot of greater fools out there, and, besides, the paper hadn’t defaulted. Then your performance wasn’t as good as the performance of the optimists, and the subsequent rounds of new money went to them instead of you.

As we all know, all that’s changed over the past two weeks. People in the junk and distress markets use the catch-all description of “GM” to mark the change, referring to GM’s profit warning and the subsequent sell-off. The Fed played a part in this too; even before last week’s Fed Funds rate hike, it was beginning to signal that a harder line against inflation was called for. That meant that the cheap money that paid for the carry trades was at risk.

While the big new money in junk and distress that’s managed by people with a good half-cycle of market experience is doubling up on its SSRI drug dosages, the older investors are heartened.

They may not have kept all their own teeth, but they still have their own money, and they’re looking forward to making a lot more.

“There’s been an extreme level of overcapitalisation,” says one hedge fund distressed debt investor who’s been in the market through three economic cycles.

She wants to take the new funds’ money, and what’s different about this cycle is that the credit default swap market gives her an easy way to do it. “For example, look at what the (new money) was doing in Salton ( the home appliances company). Salton has an August ’05 issue, and company performance has been very weak. But as late as February, those bonds were trading in the low to mid 90’s on the hope and belief they could be refinanced. In the last couple of weeks, those bonds have come down almost 15 points.”

In the distant past, in 1991 and before, it was very hard to sell junk bonds short. It was expensive, since before they actually default the yields are high, which means the short seller had to come up with a lot of cash on each payment date. Furthermore, the mechanics of shorting bonds were more involved, since you had to obtain “term repos” for illiquid paper - not easy. “With the CDS market, it’s a lot easier,” says our distressed debt investor. “There’s a lot of liquidity in the on-the-run (current) issues.”

Even after the “GM” sell-off, junk and distressed prices still don’t, in many cases, fully reflect the underlying risks. For example, when the junk and distressed managers who are still in their first business cycle calculate the recovery values of this paper in the event of a default, they assume it will be priced somewhere between seven and nine times the cash flow. In a recession and market slump, that multiple could be as low as four times cash flow, if not lower.

The fights in bankruptcy courts could also be more difficult this time around. In previous recessions, the larger firms filing under Chapter 11 would typically have substantial unpledged assets that could be used to secure a debtor-in-possession financing. This time, though, companies in industries such as the independent power producers have in many cases already pledged their valuable assets. That means that in order to keep them operating while in reorganisation, some creditors will have to either put up new money, or give up some collateral. Not an easy sell. Good for legal fees, though.

Still, even now there are some attractive trades to be done. For example, however gloomy you may be about GM’s long term assets, it is very unlikely that it will file for bankruptcy in the next two years. Very unlikely.

So you can “sell protection”, or go long GM in the CDS market, the equivalent of extending the company credit. At the end of last week, you could collect about 448 basis points for doing so.

Then you can hedge this optimism by selling short the five year BB component of the CDX index (a cross section of the better grade of junk). The spread there is 362 basis points. If GM is downgraded to junk within two years, the two positions should converge. You make close to a hundred basis points for a reasonably hedged bet.

The real opportunities, though, are two to three years off. By then the newbie junk and distress managers will have given up on Corporate America and sold their second homes. At that point, the veterans will hoover up their leavings.

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