“After rocking the stock market in recent days, WorldCom Inc.’s woes are starting to hit hedge funds and the entire corporate bond market, raising red flags for the rest of the economy,” writes Gregory Zuckerman in today’s Wall Street Journal.

“Traders say the WorldCom fallout, which has produced one of the worst stock-market weeks in years, also is causing serious dislocations in credit markets, making it difficult to trade all kinds of corporate bonds, because buyers suddenly are in short supply. If things get worse, analysts fear a number of big firms may have to bail out of their positions in WorldCom and other bonds, causing more damage to the market.”

“The pain has spread throughout the corporate bond market, hitting both investment-grade and junk bonds, especially companies like Qwest Communications International Inc., Tyco International Ltd. and AOL Time Warner Inc.’s America Online, which have been accused of using aggressive accounting or have seen executives under fire.”

“The $2.2 billion Obsidian hedge fund run by BlackRock Inc., which boasts one of the best long-term track records in the bond business, fell 7.5% in June, an unusually steep decline for a bond hedge fund accustomed to grinding out steady returns. The hedge fund is down about 10% for the past two months, according to investors in the fund, and is down 2% so far this year.”

“Firms that specialize in so-called distressed debt have done even worse. Owl Creek Asset Management LP, a $100 million New York hedge fund, has lost about 11% during the past month, according to investors. Many distressed hedge funds bought WorldCom’s bonds when they fell to about 40 cents on the dollar last month, but have seen it tumble further to 15 cents.”

“While those losses pale in comparison with the pain from some stock mutual funds this year, they are startling for investors who have flocked to bond funds to avoid the heavy losses in the stock market. For many bond hedge funds, the past 10 days have been the worst period since Long-Term Capital Management ran into trouble nearly four years ago. That crisis sent the overall bond market into a tailspin.”

” ‘June has been as bad a month for hedge funds as we’ve seen since September of 2001, and in some cases it’s been worse,’ says Evan Roth of BBR Partners, a firm that invests in hedge funds for clients.”