Distressed debt is losing ground with hedge funds as there is less and less room for price appreciation. Otherwise, hedge funds are following the same strategies and using the same asset classes as they were three years ago, according to a JPMorgan’s Global and North American Heads of Prime Brokerage Kumar Panja and John Cotronis. Although competition to attract institutional investors was putting pressure on performance fees, they found that most hedge funds were growing steadily, hiring more people, and generally optimistic about the next few years.
“The strategies employed by hedge fund respondents were fairly consistent from 2010 through 2012 with the exception of credit/distressed,” the two analysts wrote. “This decrease may reflect what hedge funds view as a diminishing opportunity set in the credit arena since little room may be left for price appreciation.”
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What is distressed debt
Distressed debt involves buying debt with a high risk of not performing at a deep discount, and then either collecting on the debt or selling it off to a third party. For dedicated distressed debt firms, reselling the debt is usually seen as a way to limit losses when a particular investment is going worse than expected. But for many financial firms who wouldn’t have the manpower to implement a tough collections policy in the first place, the hope is that the risk will be seen to drop, allowing them to resell for a profit.
Hedge funds moving out of distressed debt in large numbers means that they don’t see much opportunity for the risk associated with distressed debt to drop, so there’s no reason to get involved.
Affects of distressed debt on economy
It’s often hard to tell whether a drop in attractive distressed debt assets is a positive or negative sign for the rest of the economy. On the one hand, it implies that people who can’t pay their bills now won’t be any more likely to be able to pay them next year. But it also means that there are fewer people with non-tangible assets (such as marketable skills) falling behind on payments in the first place.
The survey also found that hedge funds were allocating fewer assets to commodities and that they were increasing their exposure to Japan.