Sicilia recommends that the first port of call for funds seeking to take advantage of the market dislocation should be to check the capabilities of its existing bond managers. “We extended the mandate of [international bond manager] Loomis Sayles in 2006,” he says. “It wasn’t because we foresaw the credit crunch. We made a decision that we wanted to move the capitalisation structure, so we gave the managers the discretion to switch between high-yield debt and bank loans. The manager has the freedom to move and take advantage of opportunities as they arise, the legals and due diligence is already done, and when the opportunity dries up the manager can go back to focussing on the original mandate.”

While the opportunity may be short-term, ARIA’s Tarditi says that dislocations in markets can provide attractive entry-prices to sound investment strategies for the long-term. “Distressed debt is a genuinely compelling long-term investment strategy because it is diversifying and the market is inefficient, given that many investors are forced sellers of debt on downgrades,” she says. “But a primary issue when acute dislocations arise is that there is often an influx of new managers seeking to capitalise on the theme to grow their funds under management.”

She cautioned that in this environment, the success of the investment is likely to be heavily reliant on employing managers with deep experience in identifying which risks to take and which to avoid, as well as ensuring that the strategy satisfies overarching risk controls for the fund overall.

Which opportunity?

Whether to go through the hassle of appointing a specialist manager appears to depend on whether the investor sees the dislocation caused by the credit crunch as an isolated aberration with its own opportunities, or the beginning of the next deeper and longer distressed debt cycle.

With so many mangers offering different strategies, it might be both. For instance, Wall at Putnam says that institutional investors with a tolerance for illiquidity are well placed to take advantage of an unusually high liquidity risk premium. He says that in derivates with no credit risk, such as AAA rated commercial mortgage-backed securities, the yield has gone from a historically stable 25 basis points (apart from a small blip when the hedge fund Long Term Capital Management imploded) to a yield trading at between 100-300 bps, “depending on which month you look”. Wall says what is most distressed in the current market is liquidity; the opportunities in credit risk are still some time away. Derek Stewart, managing director at Mellon Global Alternative Investments, was in Sydney in July to talk to institutional investors about opportunities in the Mellon Recovery Fund, a hedge fund of funds dedicated to distressed debt.