There are signs that investors are gathering more capital for distressed debt investing, yet distressed investment seems to be lagging, even as the primary high yield market booms. Observers note that macroeconomic fears may be keeping investors away as defaults and bankruptcies are expected to spike.

The California Public Employees Retirement System (CalPERS), which manages $169 billion in assets, could dedicate as much as 3% of its total assets, or approximately $5 billion, to distressed debt.

This would include “toxic” mortgage-backed securities and securities issued under the U.S. government’s Term ABS Lending Facility (TALF), as well as U.S. corporate high yield bonds and leveraged loans. A CalPERS investment policy subcommittee could approve a distressed investing program June 15, which would clear the way for consideration at an Aug. 17 meeting of the fund’s investment board.

CalPERS would be following the lead of private investors such as Oaktree Capital Management. Oaktree, which raised more than $14 billion in two distressed debt funds two years ago, is in the market to raise another fund, according to Dow Jones New Service. The firm is reportedly targeting between $4 billion and $6 billion for the new fund.

At the same time, distressed investing may begin to look more inviting, according to some of the latest performance data. U.S. distressed debt funds have seen returns of 39.5% so far this year, according to Bank of America Merrill Lynch. For the month of May, distressed funds posted returns of 25.4%, ranking behind only emerging market equities, according to a research report BofA published June 1. According to the BofA analysts, yields on distressed debt accounted for 95% of the gains made in the High Yield Master II index last month. The Master II index climbed more than 25% from Jan. 1 through May.

But the capital that investors are sitting on has yet to really be put to work, say market observers, even though there are many distressed securities available to invest in. “There are those with a lot of money and no place to put it, and people with a portfolio that needs a lot of money, but the two sides don’t ever seem to get together,” said John Monaghan, a corporate restructuring attorney with Holland & Knight. Speaking on a distressed debt panel at the New York Society of Security Analysts 19th Annual High Yield Bond Conference on June 10, Monahan pointed out that while the amount of interest in distressed debt is high, investors have been slow on execution. “There’s a lot of dry powder, and no one to shoot at,” he said.
Monaghan, who leads his firm’s corporate restructuring, creditors’ rights and insolvency group, was joined on the panel by Adam Cohen, publisher of Covenant Review, and Anders Maxwell, a managing director with P.J. Solomon Co.

Cohen observed that the investors who helped make the market frothy during the bubble years were not back in the market looking to invest in distressed debt just yet. These investors are likely waiting until returns are higher and more assured; investors still carry a strong aversion to risk, he said. Though many of these investors could easily reallocate resources to step up their distressed debt investing when their confidence in the market returns.

Maxwell noted that investors are not putting their dry powder to work in distressed debt because the larger macroeconomic picture is still uncertain. “No one really has a perspective on the macros. Lacking that, any shrewd investor is going to be very standoffish,” he said. “It’s hard to find, among all these hedge funds and all these supposed distressed investors, any unanimity as to what looks attractive here. And nothing looks compelling.”

Maxwell said that the uncertainty in the market has been complicated by the federal government’s interference. “With the administration taking such a proactive role, that’s just one more risk factor that tends to keep people on the sidelines.” He describes the increased issuance in the high yield primary market as a “dead cat bounce,” and he predicts the lack of a sustainable recovery in high yield primary will be evident this summer.

The industry expects to see a spike in defaults and bankruptcies, which will at once provide more opportunity for distressed investors and a more negative economic environment for investment generally.

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