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The lure of distressed debt quickly fades Add to ...

Distressed debt is suddenly looking much less sexy, particularly in the United States, as the markets continue their recovery. Now big hedge funds and proprietary traders are moving down the capital structure, betting on a surge in common stock prices to bump up their 2011 returns.

The findings come out of a survey commissioned by Macquarie Capital, Bingham McCutchen LLP and Debtwire, who interviewed hedge fund managers, prop traders and other asset managers.

Admittedly, surveys come out all the time, but this one was particularly striking because a shocking majority of respondents felt the same way about distressed debt. For instance, almost 80 per cent of them are cautious and do not plan to increase the proportion of their portfolio allocated to the paper this year.

Instead, they are moving down the capital structure into things like common shares, convertible bonds and preferred mezzanine debt. These securities have not ranked this high in the annual survey since 2008.

"No longer is there a need to be at the top of the capital structure. Unlike last year where first and second lien loans were the place to be, fund managers are prepared to move away from secured debt and are ready to enter on the ground floor," noted Ronald Silverman, partner at Bingham McCutchen. "If fund managers put their money where their mouths are, we should expect the equity markets to be buzzing in 2011."

Because asset prices had such a run up in 2010, "distressed debt investors will be forced to take more aggressive risk positions to chase higher yields," noted Ford Phillips, managing director at Macquarie.

However, if investors want to continue chasing returns in distressed debt, the resounding belief was the real estate is one of the few sectors in which big gains might still exist.

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