“Hedge funds tend to go wherever the action is,” says Blythe Masters, head of global credit portfolio management at J.P. Morgan Securities.
The action these days is in the credit derivatives market. According to biannual surveys of traders by the British Bankers’ Association, the use of credit derivatives has surged almost 11-fold, from an estimated $180 billion in 1997 to about $1.95 trillion in 2002. Traders are forecasting that the market will approach a stunning $4.8 trillion by 2004.
Credit derivatives allow counterparties to limit the credit risk resulting from an investment or other type of corporate relationship. If a participant in a transaction has a credit problem, the other parties have a measure of protection. The derivatives also allow a counterparty to take on additional risk in hope of garnering higher returns. In both cases, the underlying asset -- typically, a bond issue or loan -- is not actually traded.
By far the most common derivatives are credit default swaps; less frequently, they are credit spread options, offsetting the risk of declining creditworthiness. For instance, the legion of convertible-bond hedge funds can trade away the credit risk on the debt portion of their holdings while keeping the equity option.
Factors ranging from increasing corporate bankruptcies and defaults to regulatory pressure on banks to better manage credit risk have driven investor interest. “The growth is distinctly a function of the increased volatility in credit,” says Jonathan Dorfman, co-head of global investment-grade trading at Morgan Stanley.
Volatility has fostered liquidity by attracting new entrants. The market players in the BBA survey predict that hedge funds will account for 13 percent of the volume of credit derivatives in 2004, up from 3 percent in 1999. In turn, banks are expected to be less influential. In this far larger market, survey respondents forecast they will make up 47 percent of volume in 2004, down from 63 percent in 1999.
Liquidity begets liquidity. “Increasing liquidity in many companies increases the accountability for credit risk,” says Hilmar Schaumann, chief trading and investment officer at Primus Financial Products, a triple-A-rated investment house created last year to specialize in credit risk by selling protection on investment-grade corporates and sovereigns. “Risk is not a God-given thing. It is something that can actively be managed,” Schaumann adds.
So where’s the rub? There have been regulatory noises -- most notably in the U.K. -- about whether there is “naive capacity” in the market, meaning that users might not fully understand the risks they are taking on. The rebuttal: The transparency of credit pricing and the market’s savvy participants make it unlikely that anyone is unknowingly entering highly risky transactions.
There is another problem, too. Recent published reports said the office of New York State Attorney General Eliot Spitzer is looking at whether New York hedge fund firm Gotham Partners Management Co. bought protection on certain credits to create the impression that they were deteriorating and to make a profit as a result. Both Spitzer and Gotham declined to comment.
Because Wall Street professionals still account for the bulk of credit derivative activity, the market has not proved to be a universal panacea. Corporate usage hasn’t taken off. Frank Hilton, chief credit officer at American Electric Power Co., which has been a user of default swaps, notes that the market is still keyed to issuers of debt. But companies may have their largest exposures to counterparties that don’t issue debt, or only do so in small amounts. Even when there is a match between the reference asset and the credit risk the corporate faces, “the level of risk we look to hedge is so large that a one-time program would drive up the price,” says Hilton.
Future market growth will depend on credit volatility. Says J.P. Morgan’s Masters, “While certainly better than the ghastly 2002, there is no sense in which anyone can feel 2003 is going to be totally relaxed from a credit perspective.”
