The Impact of Leverage on Credit-Oriented Hedge Fund Assets

Date: Monday, June 11, 2007
Author: Lenny Broytman, Risk Center

Fitch Ratings has warned investors that the next market downturn could have the potential to affect credit-oriented hedge fund assets in a very negative way.

According to Fitch Managing Director Roger Merritt says that the impact of hedge funds “cannot 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. That ‘effective leverage’ is what amplifies the impact of hedge funds on the credit markets.”

According to an article on institutionalinvestor.com, the International Monetary Fund (IMF) is saying that credit-oriented HF assets increased an astounding 600% in 2005 (the increase since 2000). Furthermore, the IMF has indicated that the same type of hedge funds currently make up 60% of the trading volume in the $30 trillion credit default swap market and also employ leverage of five or six times.

According to Fitch, liquidity is among “the more important issues facing credit investors in the near-term.’ In addition, Fitch noted that “the inherent stability of hedge funds as an investor class… is distinctly different from more traditional buy-and hold institutional investors.”

A February 2006 article posted on gtnews.com discussed credit-oriented hedge funds as quickly becoming an important source of capital for many of the credit markets.

Their report, now over a year old, highlighted some of their finding regarding the hedge funds they categorized to be legitimate concerns as having the potential to become “inadvertently exacerbating risks.” The following eight points, which can now be viewed with crystal-clear, 20/20 hindsight, were taken from the February 28 article. Their findings were as follows:

• Credit-oriented hedge funds are growing assets under management at a faster pace than the overall hedge fund market, and their impact in the credit markets is not well understood.
• Hedge funds' impact in the global credit markets is greater than their assets under management would indicate due to their higher trading volume and willingness to invest in higher risk markets, such as high yield corporate securities and subordinated structured finance tranches.
• Hedge funds appear to be adding liquidity to the credit markets, as a growing number of individual funds pursue differing strategies even within the same collateral sectors.
• Nonetheless, the potential for credit-oriented hedge funds to move in lock-step in response to some market dislocation cannot be ruled out.
• A forced deleveraging of one or more large credit-oriented hedge funds would likely be felt most immediately in the form of price declines and spread widening. In particular, such an event could be felt across multiple segments of the credit markets, rather than being contained to one or a few sectors.
• Secondary effects of such a deleveraging could include some potential rating volatility in the high yield corporate sector, as these companies are often reliant on access to liquidity and refinancing needs.
• Tertiary effects could include reduced issuance of high yield corporate and structured finance securities, as hedge funds shrink their participation, although this may be offset over time by traditional investors increasing their exposure to these markets.
• The rapidly emerging role of hedge funds has important implications for the credit markets. Specifically, the degree to which these important new investors diffuse capital markets risks or may move more in lock-step in response to future market dislocations is relatively unknown at this time. In effect, it is valid to ask: "Has credit risk exposure become more diffused, or has it become reconcentrated within certain hedge funds?"

Fitch also emphasized that leverage could have an effect on any forced selling of assets, during even a brief period of market stress.

Eileen Fahey, a managing director at Fitch, says “refinancing risky could be magnified in the next down turn.” She added that “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.”