Big hedge funds look for bargains in the corporate bond markets

Big-name hedge funds are snapping up bargains in junk bonds and other corners of the corporate bond market, betting that a sell-off triggered by a worsening global economic outlook has gone too far.

Corporate debt has been hit hard this year by fears that soaring borrowing costs will trigger a spate of defaults from groups accustomed to years of easy money. Interest rates for risky borrowers have skyrocketed.

But several managers, including Third Point’s Daniel Loeb, Elliott Management’s Paul Singer and CQS’s Sir Michael Hintze, say parts of the credit market have fallen too far relative to default risks and some are starting to build up their holdings.

“We find the current opportunity in high yield attractive,” billionaire trader Loeb wrote in a recent letter to investors, referring to companies with lower credit ratings. He has increased his bets on corporate bonds and plans to increase exposure if volatility accelerates, although he “does not expect a quick recovery”.

Loeb added: “We are seeing some of the most lucrative investment opportunities in structured credit since the Covid-19 crisis.”

Elliott, who recently warned the world could be heading for the worst financial crisis since World War II, told investors previously missing corporate bond opportunities and distressed investments are rapidly increasing, according to investor documents obtained by the Financial Times.

Ice BofA Euro High Yield Index (%) line chart showing European junk bond yields skyrocketing

And Hintze, one of the most experienced names in hedge fund credit trading, said he has used the recent fall in debt prices to buy credit positions and reduce his fund’s hedging against falling prices in the sector.

Following large falls in major asset classes, “we particularly favor opportunities in the credit and structured credit markets,” he wrote in a letter seen by the FT.

Yields on junk debt, which rise as prices fall, have risen to 7.8 percent from 2.8 percent in early 2022, according to the Ice Data Services Euro High Yield Index.

Naruhisa Nakagawa, founder of hedge fund Caygan Capital, which bets on rising corporate bond prices, said the recent widening in spreads, a measure of the perceived risk of holding corporate bonds versus very low-risk government bonds, “was little driven by fundamentals justified , so I think there was some kind of forced sale”.

In Europe, high-yield funds have suffered €12.7 billion in net outflows this year through the end of October, more than 15 percent of their assets, according to JPMorgan data, while investment-grade funds have lost €25.2 billion drains lost.

Many of the redemptions were in passive ETFs that track broad bond indices and have therefore had to sell a wide range of credit when investors sold out.

For example, assets in the iShares iBoxx $ High Yield Corporate Bond ETF have fallen by more than $10 billion since the end of 2020, mostly due to outflows.

Overall, US high-yield ETFs suffered net outflows of $17.1 billion in the first nine months of this year, according to data group ETFGI.

“Withdrawals lead to forced sales, which lead to price declines. It’s self-fulfilling,” said the head of a European hedge fund that recently bought bonds. “It’s already attractive and will probably become even more attractive.”

Lee Robinson’s Altana Wealth wrote to investors in recent days to explain that “bonds are back”. He highlighted a number of “very attractive” opportunities including Carnival Corp and Jaguar Land Rover.

A BNP Paribas survey of investors holding hedge fund assets totaling more than $380 billion

Some industry insiders also argue that defaults, which are close to historic lows, are rising but are unlikely to reach levels seen in previous crises.

For European high-yield bonds, rating agency S&P expects defaults to rise from 1.4 percent currently to 3 percent by the middle of next year, or 5 percent in a more bearish scenario, compared to 9 percent in 2008. Fitch expects 2.5 percent next year.

Line chart of number of global enterprise defaults* shows defaults higher than last year but still well behind 2019-20

And in the US, Fitch believes that outages will hit 2.5 to 3.5 percent by the end of next year and 3 to 4 percent in 2024 due to the pandemic. S&P expects 3.5 percent in the middle of next year.

“Markets are pricing in a 40 percent default rate for European high yield over the next five years. The price is tough,” says Tatjana Greil-Castro, co-head of Public Markets at Muzinich & Co.

Third Point’s LOEB wrote that even if credit spreads were up for more than a year in 2011 or 2015, investors buying the index are still up for more than a year because of the yields on offer and the impact of bond prices to earn more money.

“We expect defaults to increase as the economy slows, but not one that would justify these spreads,” he said.

Additional reporting by Katie Martin Big hedge funds look for bargains in the corporate bond markets

Adam Bradshaw

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