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Daniel Loeb has raised his bets on corporate debt and plans to increase exposure as volatility accelerates, even though he does “not anticipate a quick rebound.”Andrew Kelly/Reuters

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Big-name hedge funds are snapping up bargains in junk bonds and other corners of the corporate debt market, as they bet a sell-off sparked by the darkening global economic outlook has gone too far.

Corporate debt has been hard hit this year by fears that steep increases in borrowing costs will lead to a wave of defaults at groups that have grown accustomed to years of easy money. Interest rates for risky borrowers have soared.

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

“We find the current opportunity set in high-yield credit attractive,” wrote billionaire trader Mr. Loeb in a recent letter to investors, referring to companies with lower credit ratings. He has raised his bets on corporate debt and plans to increase exposure as volatility accelerates, even though he does “not anticipate a quick rebound.”

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

Mr. Elliott, which recently warned that the world could be heading for its worst financial crisis since the second world war, told investors that previously absent opportunities in corporate debt and distressed investing are rapidly increasing, according to investor documents seen by the Financial Times.

And Mr. Hintze, one of the most experienced names in hedge fund credit trading, said he had used recent falls in debt prices to buy credit positions and to cut his fund’s hedges against falling prices in the sector.

After large price falls across major asset classes, “we especially favour the opportunities in credit and structured credit markets,” he wrote in a letter seen by the FT.

Yields on junk debt, which rise as prices fall, have soared from 2.8 per cent at the start of 2022 to 7.8 per cent, according to the ICE Data Services euro high-yield index.

Naruhisa Nakagawa, founder of hedge fund Caygan Capital Pte. Ltd., which is betting on rising corporate bond prices, says the recent widening of spreads, a measure of the perceived risk of holding corporate debt versus ultra low risk government bonds, “was hardly justified by the fundamentals, so I think there was some kind of forced selling.”

In Europe, high-yield funds have suffered €12.7-billion of net outflows this year to late October, equal to more than 15 per cent of their assets, according to JPMorgan Chase & Co. data, while investment-grade funds lost €25.2-billion in outflows.

Many of the redemptions have come in passive exchange-traded funds (ETFs), which track broad indexes of bonds and that have therefore had to sell a wide array of credits when investors sell out.

Assets in the iShares iBoxx $ High Yield Corporate Bond ETF HYG-A, for instance, have dropped by more than US$10-billion since the end of 2020, mostly as a result of outflows.

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

“Redemptions are leading to forced selling, which is leading to price declines. It’s self-fulfilling,” says the head of one European hedge fund that has been picking up bonds recently. “It’s already attractive and it’s probably going to get even more attractive.”

Lee Robinson’s Altana Wealth Ltd. wrote to investors in recent days to declare that “bonds are back.” He highlighted a number of “very attractive” opportunities including Carnival Corp & plc CCL-N and Jaguar Land Rover Automotive PLC.

A BNP Paribas survey of investors, managing more than US$380-billion in total hedge fund assets, found that they planned to increase allocations to credit funds in all regions, with U.S. funds being the most popular.

Some industry insiders also argue that while defaults, which are close to historical lows, are expected to rise, they are unlikely to reach levels seen in some previous crises.

In European high yield, rating agency S&P Global Ratings expects defaults to rise from current levels of 1.4 per cent to 3 per cent by mid next year, or 5 per cent in a more pessimistic scenario, compared with the 9 per cent reached in 2008. Fitch Ratings expects 2.5 per cent next year.

And in the U.S., Fitch thinks defaults will reach 2.5-3.5 per cent by the end of next year and 3-4 per cent in 2024. This compares with a 21-year historical average of 3.8 per cent and 5.2 per cent during 2020s coronavirus pandemic. S&P expects 3.5 per cent mid next year.

“Markets are pricing in a 40 per cent default rate in European high yield over the next five years. It’s all in the price,” says Tatjana Greil-Castro, co-head of public markets at Muzinich & Co. Inc.

Third Point’s Mr. Loeb wrote that, even if credit spreads rose above levels seen in 2011 or 2015, investors buying the index would still make money over a year because of the yields on offer and the effect of bond prices moving back towards par.

“We do expect an increase in defaults as the economy slows but not one that would justify those spreads,” he said.

Additional reporting by Katie Martin

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