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The sharp correction in the US subprime market in mid-2007 was the catalyst for what has been a near perfect storm in global credit markets. Competing fears of recession, default, inflation and the possible collapse of a large financial institution and subsequent fire-sale of their loan book helped chase liquidity from the market and lead to a substantial re-pricing of all forms of credit risk.

Distressed securities are primarily debt securities which originate from companies that are in the process of reorganisation or liquidation under local bankruptcy law, or companies engaged in other extraordinary transactions such as balance sheet restructurings. Distressed securities typically trade at a yield-to-maturity of more than 1,000 bps over US Treasuries (UST) or below 80 cents on the dollar. Looking at the US high yield market today approximately USD 200 billion, or 28%, would be considered distressed, up from only USD 8 bn a year ago. Trading in distressed securities is highly inefficient, partly because of forced selling. A hedge fund specialising in credit is often able to purchase securities at a substantial discount to its intrinsic value.

In this paper, we briefly examine the historical growth and the cyclical nature of credit markets. Then we focus on recent developments and provide an overview of distressed hedge fund investing. Finally, we touch on the likely outcome of the current credit crisis and discuss how hedge funds can profit. We base ou......................

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