Big money managers bet big on distressed debt

By Jennifer Ablan - Analysis

NEW YORK (Reuters) - The allure of moribund mortgage bonds and corporate debt has grown so strong that Wall Street's biggest money managers are picking over their carcasses, suggesting the year-long credit crisis may be over the worst.

BlackRock Inc., Third Avenue Value Management LLC, Trust Company of the West, Pacific Investment Management Co., or Pimco, and Metropolitan West Asset Management have launched or plan to launch distressed debt funds, betting that mortgage security and corporate debt prices have fallen enough to warrant interest, even though further declines are possible.

Even influential investor Jeremy Grantham said he has doled out money to three such funds for his personal account. "A well-managed distressed fund will no doubt do very well and will have great opportunities," Grantham, chairman of global investment management firm GMO, said in an interview.

These new distressed-oriented funds by such mega money management firms that do not necessarily specialize in distressed investing -- including BlackRock and Pimco -- reflect the potentially huge windfalls, albeit in exchange for some initial loss and volatility.

The move is crucial because the behavior frequently signals that a market is forming a bottom when these firms are active or plan to be in the market.

"The way to lure cash back into the credit markets is that once you see people making money again, that begets more money into the market," said Greg Peters, head of global credit strategy at Morgan Stanley in New York.

VULTURES OF ALL KINDS

What's set money managers in motion is that defaults and bankruptcies are mounting. Already, the volume of distressed debt, or bonds trading at 1,000 basis points over comparable Treasuries, is at an all-time high, $184 billion. High-yield "junk" debt trading at distressed levels totals $147 billion, and investment-grade distressed debt is about $37 billion, according to Moody's credit strategy group.

That's the result of tightening global lending standards, rooted in monstrous mortgage defaults, and falling U.S. home prices which could eat deeply into already slowing growth and consumption worldwide.

"We are going to see a cycle at least as good as what we saw in 2001-2002," said Michael Fineman, distressed bond investor for Third Avenue, the house of famed value guru Marty Whitman.

Fineman noted that seven years ago, when credit tightened considerably amid the collapse of Enron and WorldCom, the default rate for junk bonds shot up to 10-12 percent, compared with just 1 percent for the past four years.

That suggests default rates are likely to rise much more -- allowing investors to pick up bonds at depressed levels, and profit when they rise.

Jeffrey Gundlach, chief investment officer of TCW Group in Los Angeles, which invests $160 billion, said he sold his junk bonds in May when they were posting similar returns as Treasuries. "I thought, 'This is nuts,'" Gundlach said.

"I will buy junk bonds again when they trade hundreds of basis points wider from here -- which I do anticipate," Gundlach said.

Instead, Gundlach has recently been a major purchaser of Fannie and Freddie mortgage-backed securities and non-agency securities, with some purchased at average prices of roughly 58 cents on the dollar.