Investors queuing to pour cash into discounted corporate debt are in for a risky ride as hedge funds continue to dump assets on the market and default rates have yet to peak.

There is rising interest from private equity and hedge funds to scoop up debt in secondary markets. Last year Mark Devonshire and Mark McGoldrick left Merrill Lynch and Goldman Sachs respectively to start their own funds.

We are probably getting someone coming to see us every week about raising a new debt fund, Michael Halford from law firm SJ Berwin said at a conference this month.

Data firm EPFR Global shows flows into high-yield bond funds reached a net $4.4 billion between November and early February, at a time when most fund sectors saw outflows.

But plenty of players are warning that early adopters may be burned, as continued forced selling by hedge funds could further deplete values, and defaults could still rise, threatening to deflate debt portfolios further.

The richest pickings follow the period in which default rates peak, said Chris Keen, a partner at fund of hedge funds firm Culross Global Management. He said the firm was interested in distressed debt, but not just yet.

Recovery rates are bound to be better when there's a market into which you can sell. While the numbers of distressed businesses are still rising it's more difficult to get people to take risk on the underlying assets.

Research by Edward Altman at New York University's Stern Business School confirms that the two best years for distressed investing -- 1991 and 2003 -- followed the peaking of high yield bond default rates.

BUYING HIGH...

With economists forecasting a lengthy, severe recession, and the bankruptcy cycle still in its early stages, funds that have bought assets at too high price may struggle to make their targeted returns.

The market for distressed assets could continue to fall until the second quarter of 2010, said Graham Martin, co-leader of PWC's distressed debt group.

In the UK there has been some nervousness as to when to enter the market, particularly with residential mortgage-backed securities (RMBS), and that's because of uncertainty as to whether real estate has bottomed, he said.

Investors worry about committing their own capital as they cannot obtain leverage from banks, and about the nature of government intervention.

They're concerned the government might give mortgage holidays which would affect returns, he said.

The Mellon Recovery Fund, a dedicated distressed debt fund of Mellon Global Alternative Investments, lost 20 percent in the last four months of 2008 with only 40 percent exposure.

The reason we are not buying ... in the first quarter is because we see continued selling pressure due to the Madoff scandal, said Derek Stewart, the group's director.

Our view is that this will be the biggest distressed debt cycle ever, and we are building that exposure, but very cautiously because prices are still falling, he said.

A lot of investors came into the market too early in 2008 and got their fingers burned, Stewart said. The distressed debt sub-strategy in the Credit Suisse/Tremont Hedge Fund Index - based on contributed data from 5,000 hedge funds globally - was down by 20.48 percent in 2008.

High-yield is traditionally classed as distressed when the credit spread exceeds 10 percent over government bonds. Bank or leveraged loans have been regarded as distressed when they trade at prices representing less than 80 percent of face value.

Now asset prices are falling across the board, pushing many companies to these levels whilst they are still far from default. This is tempting for investors.

Markets are still only a third of the way through the distressed cycle, said one distressed debt manager, who did not want to be named.

Respondents in a recent survey were divided as to whether to increase their allocation to distressed assets in 2009.

In the Debwire survey, 56 percent said that they would ramp up their exposure, 31 percent said they would not, and 13 percent said the decision depended on the market.

(Additional reporting by Simon Meads and Jane Baird; Editing by David Cowell)

United kingdom Investment Merrill Lynch