Investors in distressed debt see default rate hit 4%

Investing in distressed debt was one of the most successful hedge fund strategies through most of the crisis, but it was eclipsed by the bullish stock market in 2013, and many hedge funds are falling behind. are removed at the end of the year. Even though distressed debt investors have lowered their targets for 2014, many expect the waning reduction to lead to an increase in defaults and conserve cash so they can take advantage of future opportunities. as they arise.

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Declining should drive the default rate

“The prevailing assumption is that the cut will eventually lead to tougher lending standards, triggering a wave of defaults for subprime borrowers unable to secure capital market support,” a recent Bingham survey says. McCutchen LLP and Debtwire. The bearish tone is further reinforced in this year’s survey, where 21% of respondents see the default rate climbing north of 4% in 2014. within a range of 2.1% to 4%.

While the impact of tapering is expected to spread to emerging markets and Europe, distressed debt investors see the greatest upside potential in North America, likely the US in particular.

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Expectations for Distressed Debt Allocations

And while the default rate is expected to rise, at least for some, the sector has lower expectations than this time last year, and allocations to distressed debt are expected to remain virtually unchanged from 2013.

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“Lots of dry powder waiting to be deployed”

But the survey’s most surprising finding is the amount of money waiting on the sidelines as default rates rise and spawn more distressed debt.

“The fact that 29% of respondents kept more than 50% of their 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 Jonathan Alter, partner at Bingham McCutchen “Once the opportunities present themselves, however, there should be plenty of dry powder waiting to be deployed.”

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It also implies that if 2014 sees an increase in distressed debt, it could become a crowded market fairly quickly. Even if investors are willing to accept lower returns on distressed debt, they cannot be content to hold cash all year and there could be intense competition for distressed assets.

Updated

Carol M. Barragan