Hedge funds specializing in distressed debt and loans are the stars of the hedge fund universe this year, with the Hedgefund.net index of 99 funds returning 11.75% this year. This far outpaces sectors with vastly more capital and funds, such as convertible arbitrage or long/short equity, which are up 0.48% and 2.91%, respectively. Still, distressed-debt performance lags behind last year’s average 30.89%.

Distressed funds buy bonds and loans of companies that are behind in their principal and/or interest payments, or that will wind up seeking bankruptcy protection. Usually, the funds pay pennies on the dollar for the bonds and loans. Once in bankruptcy, the funds have seniority among the company’s creditors and can force asset sales to pay their bonds off. Increasingly, hedge funds are taking an activist role in the companies, taking large equity stakes in the companies as they emerge from bankruptcy.

The performance this year has been so good for several reasons. First, there continue to be numerous asset-rich but cash-flow-poor companies that need to seek protection for their creditors. Recently, several large gaming companies – including Trump Castle Casino bonds – have had their bonds deteriorate to distressed levels. Casino companies are favorites of distressed-debt investors because the companies usually have large streams of cash from gamblers; their problems usually stem from overbuilding lavish resorts.

The second is that a lot of investor capital was withdrawn or at least reduced at many hedge funds after last year’s returns. Distressed funds have always been highly cyclical, traditionally peaking in performance right before a major economic expansion. Investors anticipated that corporations would be flush with cash as America’s economy expanded, and that the stock market would be attractive. Though the economy has expanded, some companies are still getting into trouble.

The capital pulled out of distressed funds – by some accounts $2 billion – $3 billion in total – meant that there were fewer dollars chasing the most attractive situations. Moreover, hedge funds can use leverage to amplify these trades, capturing more profit. Another factor pushing distressed funds to profit is that credit spreads – the measurement of how far bonds of different credit ratings trade from risk-free Treasuries – have generally moved in closer to Treasuries. Investors have been willing to take the risk of owning bonds with lower credit worthiness in the hopes of picking up some incremental yield. This forces bond prices of even the riskiest bonds higher.