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May 9, 2008

Block Firm to Trade Distressed Debt

By Michael Scotti

Agency shop JonesTrading, known for its large network of equity sales traders, has expanded into a new asset class-distressed bonds. JonesTrading last month began trading the illiquid bonds of troubled companies for two reasons: First, customers demand was strong; and second, it believes that bond trading is migrating toward the equities model of agency trading-particularly distressed bonds.

According to Moody's Investors Service, the recent credit crunch and slowing economy have already pushed bond defaults way up-about five times what they were last year during the same period, or $1.4 billion last year compared to $7.27 billion this year. Consequently, it shouldn't come as a surprise that JonesTrading sees distressed bonds as a growth area for the firm.

"We were already trading distressed equities with customers," said Packy Jones, chairman of the company that bears his name, "so this seemed like a natural progression." Now the firm can execute the stock of a company and its distressed credits, both of which can be illiquid, he said. "If we do our job, clients won't have to pick up the phone a second time for the debt portion of a trade."

All distressed bonds trade at a discount from par-i.e., cents on the dollar. But not all distressed bonds are those of a company in bankruptcy. Distressed investors-also known as "vulture investors"-often invest in distressed bonds to take part in the workout of a company in bankruptcy. They can also invest in the bonds because they want to own the new stock in the company after it is reorganized. Hedge funds have been active investors in this area for the last 20 years.

JonesTrading won't be taking positions, but will trade as an agent on a riskless-principal basis-the way the old Nasdaq dealer market used to operate, said Will Geyer, president and chief operating officer of the firm. The same skills needed to put together a block of stock apply to bonds, Geyer said. "It's all about understanding the liquidity landscape and how to make a call to represent those trading situations to customers."

The firm hired Kerry Stein from Morgan Joseph & Co. to oversee the distressed debt operation, as well as an analyst and a trader. Stein's work will include some training of the 80 sales traders at Jones in the workings of the distressed debt world. Profits would come from a markup of an eighth or a quarter point, Stein said. Both the buyer and the seller are aware of what Jones takes from a trade, he added.

One executive at a competitor suggested that Jones' model could be a viable strategy. Typically, the sales trader in distressed debt at a firm is also an analyst, he said, explaining that clients want to talk to someone who understands both the asset class and the credit. However, without knowing the specifics of the plan, the executive also said that Jones could have difficulty penetrating the top accounts in this area. "Some of these accounts are very sophisticated," he said.

But Jones executives said they are already talking to the top accounts. Stein said that customers are really just looking for color on the names and for access to liquidity. "At the end of the day, the clients are doing most of the deep research," he said.

TRACE, the tape run by FINRA that reports fixed income trades, has changed the dynamic trading in that asset class, Stein said. That transparency is one reason bonds trade more like equities. But for distressed bonds, in particular, broker-dealers do not want to take positions because of the wide swings in price that can occur in a day. That's why a wide network of sales traders working on a riskless-principal basis is a good model, he said.

Avoiding or limiting market impact, Stein said, is the goal in distressed bonds. And that is best done by putting up large trades-$20 million to $25 million of face value. But a typical bond trade is $1 million or $2 million of face value, he said. "When they trade in onesies and twosies," Stein said, "the price movement can be phenomenal."

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