Hedge funds’ swift exit

Speak to any investment banker working in credit and they’ll all say the same thing: the growth of hedge funds in the credit markets has fundamentally changed the way they operate.

There is universal agreement concerning the range of products hedge funds are using, notably capital structure arbitrage and credit default swaps.Responsibilities have been re-allocated, and resources re-directed, with the best of breed moved over to deal with new, and very demanding clients.

Each bank has a clear idea of how its own trading books have changed; but no-one has any real indication of what is happening in the wider market (although Risk will be producing a detailed report on hedge funds in the credit markets in its forthcoming April edition).

But if you want to know how influential hedge funds have become in credit, look no further than the sudden correction in credit spreads that began in late January.

A correction was far from unexpected – credit prices were far too high, and seasoned observers will tell you that they had been driven to their heights largely by hedge funds.

But what caused investment-grade credit spreads to plummet 20% from their mid-January highs in the space of only a few days? Look no further than the hedge funds.

And, according to the investment bank credit trading desks, much of this correction was driven by the credit default swap market, where spreads suddenly snapped back from being noticeably tighter than in the cash bond market to a number of basis points wider.

That move was driven by hedge funds deciding to exit credit positions as quickly as possible – and, with most real-money managers sitting on the sidelines, not changing their positions, the fastest route out was to buy protection through the CDS market.

The increased availability of credit derivatives has given hedge funds much more influence in the credit markets than the actual volumes they have under management would indicate. (For example, even in the US high-yield market, experts estimate they account for little more than 5% of holdings.)

If funds are looking to generate excess returns in 2004, maybe they could seek reward in the nascent equity default swap market that a small number of banks are touting as the next big thing (page 24).

Pension funds are being encouraged to allocate more of their assets to hedge funds, but as the lead story in our Risk Management for Investors special report shows (page S2), it’s a slow process. But at least they haven’t suffered the reputational risk-related outflows of mutual funds such as Putnam who, as described in our article on page S6, are now trying to rebuild trust in the market.

On the subject of trust, there seems to be little between regulators and companies when it comes to the thorny issue of accounting for stock options, as this month’s cover story details on page 21.