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Hedge funds find new openings in low-leverage world

Date: Thursday, April 3, 2008
Author: Laurence Fletcher, Guardian.co.uk

LONDON, April 2 (Reuters) - Exploiting opportunities created by wild market movements, rather than loading up on leverage, will be the key to hedge fund returns this year.
While prime brokers tighten credit lines as the credit crisis unfolds, hedge funds see excellent opportunities arising from panic selling, particularly of credit, by nervous investors -- sometimes even by other hedge funds in trouble.
"We may be able to make our 10 percent plus return by having greater disparities in front of us but less gearing," said Tim Haywood, chief executive and chief investment officer of Augustus Asset Managers.
"I think maybe that's where we're going to spend the rest of the summer."
According to a survey by Britain's Financial Services Authority, leverage fell from more than seven times to less than three times in fixed income arbitrage strategies -- the most leveraged type -- between October 2006 and October 2007.
"Part of this is due to prime brokers cutting back exposure to hedge funds but another part has been hedge funds cutting back themselves because of the uncertainty in financial markets," said Odi Lahav, head of Moody's European Alternative Investment Group.
The lower leverage and volatile markets have affected returns in a $2.5 trillion industry that has the ability to make money in all market conditions.
August and November last year saw falls of 1.53 percent and 1.21 percent respectively, according to Credit Suisse/Tremont. In the first two months of 2008 funds are up just 0.10 percent, with fixed income arbitrage down 0.38 percent.
However, while the credit crisis means the end of easy borrowing for hedge funds, it has also meant the start of new opportunities for the arbs in a variety of riskier assets as investors rush into the safety of cash or government debt.
"If you look at long/short equity books, because people just had to sell holdings and in some cases pay investors their money, that's created big dispersions in terms of valuations across large swathes of equity markets," said Tim Gascoigne, global head of portfolio management at HSBC Alternative Investments.
Comparisons are being made with 1998, when the collapse of hedge fund Long Term Capital Management and Russia's debt default sparked a global financial crisis, and the subsequent strong market rally in the final months of 1998 and into 1999.
"You tend to see strong performances after a period of dislocation or deleveraging," said Gascoigne. "During 1999 there were some great returns from arbitrage managers ... because of the dislocations that took place in the last quarter of '98."
In credit, yields on euro-denominated "junk" bonds have soared to 11.39 percent at the end of the first quarter, 765 basis points over government bonds, from 6.19 percent a year ago, according to Merrill Lynch data.
Investment-grade corporate spreads versus government bonds have more than tripled, meanwhile, to 187 basis points from 48 basis points over a year ago. Many analysts regard this as very attractive given the relative strength of investment-grade corporate balance sheets.
While cash bond spreads have continued to move wider, the cost of insuring European companies' debt against default has fallen sharply since mid-March, opening up a growing gap between the two. The iTraxx Europe index of 125 investment-grade credit default swaps has fallen from a peak of 166.5 basis points to 112.5 basis points.
This has led to some attractive opportunities whereby investors can buy a company's bonds and buy credit protection -- a so-called negative basis trade -- locking in the difference between the two.
For instance, when Casino priced a 5-year bond last week, it paid investors a spread of 225 basis points over mid-swaps, while its credit default swaps were at 160 basis points. An investor who bought both would lock in the 65-basis-point difference while theoretically having no exposure to Casino default risk.
"This feels very much like the really crazy moves of August '98, whereby certain financial variables were moving at a speed and distance that was almost unimaginable," said Augustus's Haywood, who plans to start buying corporate credit in June.
"The situation created is that there is tremendous potential disparities between equities and bonds, between bonds and CDS (credit default swaps), between bonds and inflation-linked bonds. Relative value opportunities are appearing everywhere." (Additional reporting by Richard Barley; editing by Sue Thomas)