Credit hedge funds profit as companies face soaring borrowing costs

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Credit hedge funds that focus on distressed debt are making bumper profits this year as the rise in borrowing costs hits weaker companies. 

Central bank rate increases have put pressure on some small and medium-sized corporate borrowers considered riskier credit, forcing them to offer significantly higher rates to tempt potential lenders.

It has also made existing riskier debt cheaper, increasing yields and offering the opportunity for better potential returns.

After a more challenging 2022, the Eurekahedge distressed debt hedge fund index was up 5.9 per cent on Friday, the highest performing strategy of the year so far.

“The higher for longer [interest rate] environment that we’re in, has created attractive opportunities in the credit spectrum,” said Danielle Poli, portfolio manager and managing director at $172bn credit investor Oaktree. 

Analysis from the special situations team at credit fund Alcentra shows that about €120bn in European bonds and loans are trading at distressed levels, above interest rates of 12 per cent, double the roughly €50bn or €60bn seen in 2019. The analysis only considered debt with an issue size above €100m. 

Richard Deitz’s hedge fund VR Capital returned 18.2 per cent by the end of July, making it one of the year’s best-performing funds, according to a person who has seen the numbers. The fund has $4.9bn in assets under management and mainly focuses on distressed companies in emerging markets. 

Jimmy Levin’s Sculptor has seen his Credit Opportunities fund, which manages $1.4bn in assets, return 8 per cent to the end of August. About two-thirds of the fund is invested in corporate debt, while the remaining third is invested in structured credit vehicles that contain loans. 

The better performance marks a reversal from last year, when credit investments were hit by falling bond prices as central banks raised rates. VR and Sculptor were down 5.7 and 4.1 per cent, respectively, last year.

“Last year, performance was heavily impacted by the increase in rates, which led to credit issues and a lot of forced selling across the board,” said Allan Schweitzer, a portfolio manager at credit hedge fund Beach Point.

Hedge funds have also made money by providing loans to companies struggling to borrow from banks.

A $5.5bn fund from King Street is up 4.75 per cent to August 25, with part of the performance driven by lending opportunities to smaller companies backed by private equity firms. 

“The debt market for sponsor-owned single B or triple C rated debt has generally been closed for 18 months,” said Paul Goldschmid, partner and co-portfolio manager at King Street.

“This is a real issue for these firms, and we are providing capital to a number of these companies which are facing cash flow issues and that need to refinance their debt or help fund their negative free cash flow issues.”

The tougher fundraising environment has given hedge funds much more negotiating power to ask for interest rates of 14 per cent or higher, while building in tougher covenants to ensure they are repaid. 

“I think this is a golden age for fresh credit because legacy credit has a lot of flaws in it, not least a lack of covenants,” said Stuart Fiertz, president of London-based Cheyne Capital.

“We can come in with very good covenants and shape the transaction any way we like.”