Readers may notice today that we are a bit heavy on Financial Times stories. In part, that’s because the FT has a healthy respect for the fixed income markets.
Political consultant and pretty scary guy James Carville once remarked, “I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter… but now I want to come back as the bond market. You can intimidate everybody.” But credit conditions have been so generous over the last couple of years that many, including investment pros, have forgotten that the bond market has teeth, at least until yesterday.
The Financial Times, in an underreported news item, “Fitch highlights hedge fund risk to credit boom,” discusses a report by the rating agency Fitch on the role of hedge funds in fixed income markets.
Without using the turn of phrase, Fitch describes (apparently in a watered down fashion) a scenario called “the Great Unwind.” Fitch points out that hedge funds have become an important source of market liquidity, and have also demanded (and hence forced the creation of) high return products and favorable borrowing terms from their prime brokers (many hedge funds, particularly the aggressive traders, employ leverage).
If multiple markets were to decline together, many hedge funds would liquidate their positions, simply to try to preserve their returns. But with leverage, selling can produce forced selling (the investments are collateral for the prime broker loans; if their value declines, the hedge fund must either post more collateral or cash, and to get cash, they need to sell the investment). So a forced deleveraging feeds on itself.
This is the specter that nearly brought down the financial system in 1998, when monster hedge fund Long Term Capital Management had to sell underwater positions in a deteriorating market. The firm was so large that it could not be allowed to fail, and the Fed forced a bailout. That unwind was manageable precisely because only one firm was in trouble. We have expressed doubts as to whether a crisis could be managed if it was of similar magnitude but spread across multiple firms (from a managerial standpoint, it would be well nigh impossible to handle several simultaneous, since the LTCM example showed that they make considerable demands on the organization). We have pointed out that the Fed has recently become concerned about a possible repeat of 1998.
To the Financial Times:
Hedge funds are helping to fuel a global credit boom, but their growing influence on credit markets is likely to have negative consequences, a new report by Fitch Ratings has found.
Such funds now account for almost 60 per cent of trading volumes in credit default swaps – derivatives that provide a kind of insurance against non-payment on corporate debt. The CDS market has more than doubled in the past four years, according to Markit, the data group.
“Hedge funds’ willingness to trade frequently, employ leverage, and invest in the more leveraged, risky areas of the credit markets magnifies their importance as a source of liquidity,” the Fitch report said.
Credit-oriented strategies were one of the fastest areas of growth for hedge funds. They now have between $15,000bn and $18,000bn of assets deployed in the credit markets.
These numbers reflect high leverage multiples: hedge funds regularly borrow up to five and six times the value of their assets under management.
But the rising power of hedge funds in the credit markets has come at a cost, Fitch warned.
Innovations in the credit market, which has become a veritable alphabet soup of complex and illiquid structured products, have been largely driven by hedge funds’ demand for products that generate higher returns. Funds have also been pressuring their prime brokers to continually relax credit terms, and provide secured financing for their less liquid positions.
Consequently, investors face increased liquidity risk, since the next downturn could involve sudden and correlated declines in asset prices as funds and prime brokers try to unwind their positions.
“The potential for a more synchronous, forced unwind of credit assets cannot be discounted,” Fitch said.
“During a period of market stress, any such forced selling of assets would be magnified by the effects of leverage.”
Moreover, hedge funds have introduced a new and untested behavioural element into the markets. “Even if hedge funds retain the financial wherewithal to hold credit assets in a downturn, it is not clear whether they will have the willingness,” Fitch said.
In short, hedge funds have made it even more difficult predict how credit markets would behave if prevailing benign conditions end.
This uncertainty is significant because, according to Fitch, even a temporary dislocation in the credit markets could lead to a rash of defaults, particularly among more marginal names with upcoming debt maturities.
Investors should therefore proceed with caution.
“Of concern would be an ill-timed event that led to a sudden reversal of this liquidity across multiple segments of the credit markets,” Fitch said.