Bottoms Up for Bonds

It used to be that the term “distressed debt” referred to the bonds of companies living on the edge—highly leveraged businesses in hard-hit industries with operating challenges that stressed their ability to pay off their loans. Now, in the midst of one of the great credit crises of our times, just about any bond, including the world’s gold-plated corporations and AAA-rated municipalities, is likely to be trading like a distressed security, meaning the pressure to sell has pushed prices down. Such is the case when liquidity dries up.

John Schumacher, senior vice president in fixed-income trading at Northland Securities, Inc., a brokerage firm in Minneapolis, earlier this year launched a fund to capitalize on the distressed bond situation. His fund comprises most types of bonds, including corporate, municipal, and convertible bonds. The big question: What’s the risk that things could get far worse before they get better?

How have we reached this point?

Schumacher: Leverage. Borrowed money was flying into commercial real estate, high-yield corporate bonds, commodities, and even municipal bonds were bought with borrowed money and leveraged vehicles. Now, as it’s become difficult to borrow to finance these strategies, we’re seeing a lot of leverage come out of the market. Originally, the cost of financing these strategies was relatively cheap and easy. But as lending became more expensive, we’ve entered into a negative feedback loop that has fed on itself really quickly and pretty dramatically.

Do you look at all classes of bonds?

Schumacher: Yes. You have some very good, creditworthy bonds trading as if they’re distressed. That makes for a very interesting opportunity.

What percentage of your portfolio is below investment-grade quality?

Schumacher: That, of course, is a very fluid situation. But I would say that over one-third of the portfolio is investment-graded bonds, but that doesn’t mean that they’re liquid or without risk. The rest are either below investment grade or simply without a rating.