Impact of hedge funds on credit markets continues to expand, says Fitch Ratings

Date: Tuesday, June 5, 2007
Author: James Langton

Liquidity risk is among the more important issues facing credit investors in the near-term of hedge funds’ on key segments of the credit markets continues to grow at a dramatic pace, transforming both the cash and credit default swap markets, says Fitch Rating, and it warns of lurking liquidity risks.

Credit-oriented hedge fund assets are reported to have reached over US$300 billion in 2005, a six-fold increase from five years ago according to the IMF. Based on research published by Fitch today, this number excludes the ‘multiplier effect’ of leverage and, therefore, understates the real amount of credit risk taken and the impact on trading volumes. US$300 billion of assets equates to US$1.5 trillion-$1.8 trillion of assets deployed into the credit markets at typical leverage levels of 5-6x.

“The impact of hedge funds on the credit markets continues to expand. Their impact, however, can not be measured simply by trading volumes. One must also consider a funds’ willingness to employ financial leverage and to be ‘risk takers’ by investing lower in the capital structure,” says Roger Merritt, managing director in Fitch’s Credit Policy Group. “This ‘effective leverage’ is what amplifies the impact of hedge funds on the credit markets.”

The rating agency says that the growing role of hedge funds in the credit markets represents a true paradigm change. Hedge funds now account for nearly 60% of the trading volumes in the US$30 trillion CDS market, and provide significant capital flows to all areas of the cash credit markets, particularly more levered, subordinated risk exposures in pursuit of higher returns.

Fitch surveyed a number of global prime brokers who are the primary providers of financing and risk oversight for the industry. It notes that leverage measures, in particular, can provide one indication of the degree of risk in the system coming from hedge funds, particularly the potential for ‘liquidity dislocations’ in any credit downturn.

Given the importance of hedge funds to market liquidity and the implications of a forced selling scenario, Fitch believes liquidity risk is among the more important issues facing credit investors in the near-term. “The inherent instability of hedge funds as an investor class - arising in large part from their reliance on short-term, margin-based leverage - is distinctly different from more traditional buy-and-hold institutional investors and relationship-oriented bank lenders,” it says. “In a market downturn, the potential for a forced unwind of credit assets can not be discounted, which in turn could lead to correlations that are different than historical expectations. For example, Amaranth was reported to have sold leveraged loans and RMBS to meet margin calls on its natural gas positions. During a period of market stress, any such forced selling of assets would be magnified by the effects of leverage.”

Tight credit spreads and abundant capital has allowed even the most distressed issuers to readily access funding and refinance maturing debt, the rating agency points out. This is apparent in the low default rate for corporate debt - well under 1% year-to-date based on Fitch’s U.S. high yield index - even as many credit metrics have eroded, it says. “Even a temporary dislocation in the credit markets could negatively impact funding access for more marginal credits with upcoming debt maturities, leading to a rash of defaults,” it warns.

“Refinancing risk could be magnified in the next downturn, and credit investors need to have a robust view of liquidity sources and uses, including on- and off-balance sheet debt, upcoming maturities and contingent liquidity claims,” says Eileen Fahey, managing director, Financial Institutions and co-author of the report.

Given these changing dynamics, Fitch has instituted initiatives to heighten transparency on the issue of liquidity. This week, Fitch will be publishing a commentary reviewing the agency’s liquidity analysis for corporate issuers. This will examine the changing landscape of liquidity providers, the assumptions Fitch analysts make regarding access to liquidity at different levels of the rating spectrum and the impact of covenants, rating triggers and other qualitative factors on the rating process.

The agency has also recently concluded a wider review of its overall criteria for assigning short-term ratings in corporate finance, initiated in October 2006, and revised criteria emphasizing the priority accorded to liquidity analysis within these ratings will be published in the coming weeks.