Hedge funds move to credit-investing strategies

RMA Journal, The, July-August, 2005 by Loretta M. Hennessey

This article acquaints financial institutions with how hedge fund credit-investing strategies operate. Three strategies currently in use by hedge fund managers are the credit cross-over fund, the relative value fund, and the structured credit opportunities fund.

Hedge fund investors--Especially high-net-worth individuals and institutions-seeking consistent returns with low volatility have discovered that credit assets are the new land of opportunity. The current market offers returns in the high single digits to low teens for moderate levels of leverage in credit-investing strategies. Recognizing the value of diversification in their portfolios, financial institutions--the traditional holders of credit assets--are beginning to "market their wares" accordingly.

The financial performance of hedge funds using traditional long/short equity and convertible arbitrage strategies has been significantly reduced by a continuing flow of capital. Meanwhile, reduced volatility in equity markets and a low-interest-rate environment have exerted more pressure on hedge funds' financial performance. During the past few years, the strongest financial performance among hedge fund strategies has come from distressed debt and emerging markets, where returns have ranged from the high teens to high twenties.

A wide array of investors have taken advantage of greater liquidity and better risk-transfer instruments for wholesale loans in the primary and secondary markets, the credit derivatives market, the credit index trading market, and securitization. The funds employment credit-investing strategies are in the early stages of developing their financial track records and still represent a small percentage of the total strategies employed by hedge funds. But they are growing.

Some credit-investing strategies-those that focus primarily on bank loans--have demonstrated negative to low correlations to equities and fixed-income strategies. The standard deviation of returns among these asset classes can be observed through comparable indexes. Comparing the S&P/LSTA loan index with the Merrill Lynch high-yield and high-grade indexes and the S&P 500, the S&P/LSTA loan index loans ranked lowest relative to the others between January 1997 through March 2005. (S&P's Leveraged Commentary & Data Group uses its own data to make comparisons with Merrill Lynch and Bloomberg data.)

Hedge funds enjoy the benefits of being private investment partnerships that can use varying amounts of leverage and can take "short" positions. The portfolio manager thus can maintain highly diversified portfolios and increase the probability of stable returns even during the down part of the credit cycle.

Significant growth in the credit derivatives market has led to greater liquidity, which allows managers to "short" positions and to maintain market liquidity in their portfolios. Managing the risk return of credit-investing strategies can be done actively as market conditions change, and diversification within a portfolio can contribute significantly to stable financial performance throughout the cycle.

The Attraction of Credit Strategies

The ability to create "short" positions offers significant advantage in enhancing financial performance. The manager has greater flexibility to generate alpha (excess return). Long]short credit-investing strategies can be managed by alternating the size of longs and shorts within a fund at different points in the credit cycle.

Hedge fund managers are now able to isolate default and recovery risks and manage them more actively. Meanwhile, the dramatic rise in credit market liquidity has meant that more market prices and credit spreads can be observed and more credit is traded. Herein lies the opportunity. Credit models and the parallel growth in databases that include market prices and credit spreads have enabled managers to more explicitly demonstrate their financial performance to investors. Credit strategies can be tailored to accommodate the risk/return requirements among more varied groups of investors. These alternative strategies, when combined with other equity and fixed-income strategies, reduce return volatility.

Credit market growth. Loan Pricing Corporation's tracking of the U.S. syndicated loan market through the fourth quarter of 2004 shows the volume of loans underwritten as $1.4 trillion in the U.S.; volume in Western Europe was $793 billion. Trading volume in the credit derivatives market exceeded $5 trillion in 2004, according to the British Bankers' Association; the largest percentage of "purchased" and "sold" protection was against corporate entities. When default rates were high during 2001 and 2002, this market performed well and contracts were honored.

At the end of 2004, JPMorgan's reported CDO volume of $163 billion worldwide, with $123 billion of that total being arbitrage deals. High-yield bonds, leveraged loans, and investment-grade debt accounted for $70 billion as arbitrage deals. Credit indexes are just about two years old. Reputable financial firms that act as market makers for the indexes estimate trading volumes, at least, at $40 billion per month, which puts yearly volume at $480 billion.