Distressed debt investing was one of the top performing hedge fund strategies for most of the crisis, but it was overshadowed by the equity bull market in 2013, and many hedge funds moved away from it at the end of the year. Even though distressed debt investors have lowered their sights for 2014, many expect tapering to kick off higher defaults and are keeping cash on hand so they can seize opportunities as they arise.

Tapering expected to drive the default rate

“The prevailing assumption is that tapering will eventually lead to tougher lending standards, setting off a wave of defaults for at-risk borrowers unable to garner capital market support,” says a recent survey from Bingham McCutchen LLP and Debtwire. The bearish tone is further solidified in this year’s survey where 21% of respondents see the default rate shooting north of 4% in 2014. “That contrasts with our 2013 report, in which everyone fell in a range of 2.1%-4%.”

While the impact of tapering is expected to spread to emerging markets and Europe, distressed debt investors see the most potential for gains in North America, presumably the US specifically.

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Expectations for distressed debt allocations

And even with the default rate expected to increase, at least by some, the industry has lower expectations than it had this time last year, and allocations to distressed debt are expected to remain almost unchanged since 2013.

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‘Plenty of dry powder waiting to be deployed’

But the most surprising finding from the survey is how much cash is waiting on the sidelines for the default rates to rise and put more distressed debt out there.

“The fact that 29% of respondents have kept over 50% of assets in cash or liquid investments suggests a lack of distressed opportunities. This would certainly make sense given the low default rate in 2013,” writes Bingham McCutchen partner Jonathan Alter. “Once opportunities do arise, however, there should be plenty of dry powder waiting to be deployed.”

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This also implies that if 2014 does see an increase in distressed debt, it could become a crowded market rather quickly. Even if investors are willing to accept lower returns on distressed debt, they can’t be happy holding cash all year and there could be some intense competition for distressed assets.