Tough markets could be good news for capital structure arbitrage
By Josh Friedlander
Once upon a time, when distressed companies used to go bankrupt, hedge funds could engage profitably in at least one flavor of a tidy strategy known as capital structure arbitrage. If a company looked near insolvency, funds could buy the debt and short the stock, with the notion that, in a restructuring, the senior debt holders would recover most of their money while equity holders would get the shaft.
Since the recent heyday of capital structure arbitrage, in 2002, cheap money has flooded the markets. This excess liquidity fueled a buyout boom and meant that faltering companies were more likely to visit a private equity firm than a courtroom. Meanwhile, default rates plunged - from a high of 13% to 0.25% today - as did opportunities to short stocks and go long bonds, one of the more...