Risks of credit-oriented hedge funds remain unknown, report says

Credit-oriented hedge funds have recently emerged as important sources of capital to the credit markets, says Fitch Ratings in a report published today. However, the report cautions that the added risks that may be forming are not yet known.

The report finds that 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. Most hedge funds appear to have weathered recent turmoil in the credit markets, in part due to improved risk management practices and oversight, it says.

“Widespread hedge fund participation in virtually all facets of the credit markets is a relatively young phenomenon. As such, if several credit-oriented hedge funds de-leveraged, this could result in price declines across multiple segments of the credit markets, which could lead to increased refinancing risk and/or reduced issuance activity,” says Ian Linnell, managing director, European banks.

Fitch adds that, “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.”

The report notes that, while hedge funds appear to be adding liquidity to the credit markets, “the potential for credit-oriented hedge funds to move in lock-step in response to some market dislocation cannot be ruled out”. It adds that, “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.”

This could, in turn, lead to “some potential rating volatility in the high yield corporate sector”, and ultimately to, “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,” it says.

"While hedge funds provide much-needed liquidity to the markets, it is fair to ask whether credit risk has become re-concentrated within certain hedge funds and, as a result, whether the credit markets may be more fundamentally linked than in the past," says Roger Merritt, managing director, credit policy, at Fitch.

The report is based on feedback from leading prime brokers, industry surveys and other market participants.