Hedge funds are borrowing too much to finance their investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers, Bloomberg reports.
Hedge funds’ influence on credit derivatives and debt markets has continued to grow at a ‘dramatic pace,’ Fitch says in the report today.
In a market slump, large deals financed with borrowed money, or leverage, may ‘result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,’ analysts led by Ian Linnell in London wrote in the report for the 2006 survey.
“Until all of this recent volatility, investors had been forced down the credit quality ladder, and up in leverage to meet investment targets,” says Matt King, head of credit products strategy at Citigroup Inc. in London. “Now it appears hedge funds are deleveraging” to meet demands from their lenders.
Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank AG, Goldman Sachs Group Inc. and JPMorgan Chase & Co., Fitch said. The top 10 firms accounted for 89 percent of credit derivatives bought and sold in 2006, up from 86 percent in the previous year, Fitch said.
Banks and hedge funds say it’s cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.