Hedge funds now major players in U.S. fixed-income market, says Greenwich

Date: Friday, August 31, 2007
Author: Investment Executive, IE Staff

In structured credit, hedge funds generated nearly half the trading volume reported in the U.S. over the past 12 months.

Hedge funds generated nearly 30% of U.S. fixed-income trading volume last year, double the 15% they accounted for in the prior 12-month period, reports Greenwich Associates.

Total trading volume among the 1,333 institutions participating in Greenwich Associates’ latest study increased 10% to $US25 trillion last year. That growth represents a slowdown from the 20-25% increases seen in each of the prior three years, but it still significantly outpaced the roughly 7% growth in fixed-income assets under management in institutional portfolios -- an indication that institutions were increasing the pace of their trading activity.

Over the 12-month period covered in the Greenwich study, trading volume in distressed debt and leveraged loans more than doubled, while trading volume in below investment-grade bonds increased some 40% and trade volume in investment-grade credit bonds increased more than 20%. That accelerated pace of trading was due at least partially to the ongoing advance of hedge funds in the U.S. fixed-income market, it notes. “Fixed-income trading volume among hedge funds that interviewed in both 2006 and 2007 surged some 90%,” says Greenwich Associates consultant Tim Sangston.

“In past years, Greenwich Associates has documented the rise of hedge funds from minor players to significant sources of liquidity in certain fixed-income products. However, the recent expansion of hedge fund positions and trading activity has been so rapid and consistent that it is now no exaggeration to say that, during the 206-2007 hedge funds were no longer just an important part of the market in some fixed-income products — they were the market,” the firm says.

It reports that hedge funds currently generate: more than 55% of U.S. trading volume in liquid or “flow” derivatives with investment-grade ratings, and more than 80% in high yield derivatives; more than 85% of U.S. trading volume in distressed debt; nearly 55% of U.S. trading volume in emerging market bonds; and, more than 40% of U.S. leveraged loan trading volume.

Even in the most liquid U.S. fixed-income markets, hedge funds were expanding their presence last year, Greenwich observes. In U.S. government bonds, hedge funds are now the second-largest source of trading volume after investment funds/advisors, generating some 30% of market volume. They rank as the biggest source of trading volume in interest-rate derivatives, in which they also account for 30% of total U.S. trading volume, it says. Hedge funds generate a quarter of U.S. asset-backed securities trading volume, and 20% of volume in mortgage-backed securities.

“However, it is at the other end of the liquidity spectrum that hedge funds have become the biggest force,” says Greenwich Associates consultant Frank Feenstra. “In structured credit, hedge funds generated nearly half the trading volume reported in the United States over the past 12 months.”

For long-only investment managers and other investors, the impact of hedge funds is hardly limited to illiquid products, however. As a portfolio manager from a large investment management company says: “The hedge fund community and all its capital are the driving force of the markets these days — affecting volatility, liquidity and access to bonds.”

While the percentage of U.S. institutions trading fixed income electronically was essentially unchanged from 2006 to 2007 at about 55%, U.S. e-trading volume has been increasing steadily in some products, Greenwich says. Total electronic trading volume was essentially unchanged on a matched sample basis over the past 12 months but volume in several products increased sharply. “Institutions that do trade fixed income electronically direct nearly 40% of their total trading volume on average to e-trading systems,” says Greenwich Associates consultant Woody Canaday.

The biggest growth occurred in the MBS market, where e-trading volume increased 172%, the firm notes. In the MBS market, about 40% of institutions trade electronically, and e-trading represents 56% of total trading volume — up sharply from 30% in 2005-2006. Growth was also strong in U.S. Treasuries, where total e-trading volume increased 31%.