Credit-oriented hedge funds have recently emerged as important sources of capital to the credit markets. In particular, credit-oriented hedge funds provide critical liquidity to higher yielding, less liquid segments of the credit markets, including high yield bonds, leveraged loans, collateralized debt obligations (CDOs), credit derivatives and unrated or subordinated structured finance tranches.
In a new report, Fitch assesses the rapidly emerging role of hedge funds in the global credit markets, specifically examining the degree to which credit risk is being diffused or, alternatively, re-concentrated within hedge funds. The report relies on significant feedback from leading prime brokers, industry surveys and other market participants.
Hedge funds increasingly participate in all segments of the major credit markets. “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.
Most hedge funds appear to have weathered recent turmoil in the credit markets, in part due to improved risk management practices and oversight. Nonetheless, credit-oriented hedge funds are growing at a much faster pace than the overall hedge fund market, and their potential impact on the global credit markets is not well understood.
“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.