Hedge funds have continued to increase their exposure to credit derivatives, and may be using Credit Default Swaps (CDS) in potentially dangerous ways. Or so warn hedge fund consultants Hennessee Group.
A report issued by the International Swaps and Derivatives Association (ISDA) in September 2006 suggested the total notional value of credit derivatives outstanding globally grew 52% in the first six months of 2006 to an estimated $26 trillion. However, Hennessee is concerned that many funds are inexperienced within the derivatives markets, and may be using them in inappropriate ways.
“We believe that credit risk is being under-priced in the current environment, and credit derivatives are an effective instrument for hedge funds to mitigate credit risk within their portfolios,” says Charles Gradante, Managing Principal of the Hennessee Group.
Hennessee notes that the use of credit default swaps (CDS) by credit-oriented hedge funds has been commonplace and effectively used over the past five years. However, it also notes that the use of CDS has become more prominent among long/short equity funds over the past year.
Equity funds have been using CDS in several ways, including: a) purchasing CDS on corporate bonds designed to profit from a widening in corporate credit spreads, b) purchasing CDS on sub-prime mortgage backed fixed income securities and indices intended to profit from deterioration in credit quality among mortgage borrowers, and c) purchasing CDS on emerging market government debt designed to profit from a decline in the country’s credit quality. Instead of being used as a speculative investment, CDS have often been purchased as a hedge to portfolios of securities that funds currently own.
“While there doesn’t appear to be any imminent risks to the credit markets caused by hedge funds, we are concerned about the use of these instruments by funds that are not well-versed in how these markets trade and the dynamics of counter-party risk,” says Gradante.
Regulators have also noted the increased use of credit derivatives. The Federal Reserve last year requested dealers to improve their back-office systems for processing CDS following the bankruptcy of US auto parts manufacturer Delphi. Since then, the back-office backlog has reportedly declined substantially.
In addition, a study by Credit Derivatives Research reported that credit default swaps based on the bonds of 30 takeover targets, including four of the five biggest LBOs of 2006, rose before deals were announced, increasing the interest of the SEC.