"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," said 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 growing role of hedge funds in the credit markets represents a true paradigm change and is evidenced in a number of ways. Hedge funds now account for nearly 60% of the trading volumes in the US$30tln credit default swap 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.
To better understand hedge funds' credit market activities, Fitch surveyed a number of global prime brokers who are the primary providers of financing and risk oversight for the industry. 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. 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. 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. 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.
"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," said Eileen Fahey, Managing Director, Financial Institutions and report co-author.
