Hedge funds have amassed the greatest share of the $1.2 trillion U.S. junk-bond market since the credit crisis, raising concern bets with borrowed cash will accelerate losses when the Federal Reserve stops printing record amounts of money.
The funds, which typically use leverage to bolster returns, hold as much as 23 percent of outstanding dollar-denominated high-yield bonds, from as much as 18 percent last year and the highest since 2008, according to Barclays Plc. Credit hedge funds have boosted assets by 89 percent since 2008, outpacing the 66 percent growth of the junk market, data from Hedge Fund Research Inc. and Bank of America Merrill Lynch indexes show.
Funds that use leverage may threaten the financial system in a broader selloff, the U.S. Treasury Dept.’s Office of Financial Research wrote in a report gauging risks from investment firms that have ballooned after five years of central bank stimulus. Sophisticated investors including hedge funds were among the first to exit as the market started to fracture in 2008, when a collapse in U.S. property values triggered the bankruptcy of Lehman Brothers Holdings Inc., according to the Sept. 30 study.
“Any time leverage is involved it’ll exacerbate swings in the market,” said Marc Gross, a money manager at RS Investments in New York who oversees $3.5 billion. If a mass exodus is triggered, “they’ll all be selling and they’ll be selling with leverage.”
The Bank of America U.S. High Yield Index plunged 2.6 percent in June, more than stocks and Treasuries, after Fed Chairman Ben S. Bernanke said the central bank could start slowing its $85 billion of monthly asset purchases if the economy showed sustained improvement. In the four years before then, the debt posted average annual returns of 16.1 percent as buyers sought a reprieve from record-low bond yields.
Even as funds that use borrowed money grab a bigger proportion of the market, leverage in the system is less than it was leading up to the crisis as banks boost debt-to-equity ratios. Credit hedge funds are also, on average, using less leverage, according to Barclays’s Bradley Rogoff.
Hedge funds may, in some cases, be acting as buffers against price swings fueled by redemptions from mutual and exchange-traded funds, helping to fill a void left by banks that have reduced holdings of riskier assets in the face of new regulations, according to Gross.
‘Good Thing’
“In theory, having a more diverse group of investors is a good thing and enhances liquidity because there’s more of a chance that one group is buying as one group is selling,” said Martin Fridson, chief executive officer of New York-based FridsonVision LLC, a research firm specializing in high-yield debt. “But it’s hard to make the case that it’s going to help stabilize the markets when bonds start to really sell off.”
Hedge funds’ share of the speculative-grade bond market has grown 5 percentage points from last year to include as much as $290 billion of junk bonds, Barclays strategists led by Jeffrey Meli and Bradley Rogoff wrote in a Sept. 26 report. The 17 percent to 23 percent of the market that hedge funds own this year compares with 12 percent to 18 percent in both 2012 and 2011, according to Barclays data that doesn’t go back further than those years.
In the past year, the proportion of junk notes outstanding owned by U.S. mutual funds and ETFs declined about 9 percent, or $21 billion, to a maximum of $240 billion, the analysts said in the report. Assets owned by high-yield closed-end funds, which also typically buy with borrowed money to boost returns, doubled to about $14 billion this year, “partly in response to a desire for leverage in a low yield environment,” the Barclays strategists said.
Yields on speculative-grade bonds, graded below Baa3 by Moody’s Investors Service and lower than BBB- at Standard & Poor’s, plunged to an all-time low of 5.98 percent on May 9, Bank of America Merrill Lynch index data show. They’ve risen to 6.7 percent as the Fed considers slowing stimulus that’s helped expand the central bank’s balance sheet by $2.75 trillion since Lehman filed for bankruptcy in September 2008.
Hedge funds “have moved where the yields are, even if those yields are historically relatively low,” said Edward Altman, a finance professor at New York University who created the Z-score formula for measuring bankruptcy risk. “They’re still a good deal higher than the very low yields on” investment-grade bonds and Treasuries, he said.
Fed Stimulus
Credit hedge funds have received $113.3 billion of deposits since 2009 and boosted assets under management to $648.3 billion as of June 30, according to data from Chicago, Illinois-based HFR. That contrasts with the two years ended Dec. 31, 2009, when investors yanked $86.65 billion from the funds as the world’s biggest economy sunk into recession.
To spur economic growth, the Fed embarked on an unprecedented program of keeping benchmark interest rates at about zero and buying Treasuries and mortgage debt, pushing investors to seek higher yields by buying riskier investments.
Investors from retirees to private-equity firms piled into the riskiest company bonds, allowing borrowers to sell $1.35 trillion of dollar-denominated speculative-grade bonds since 2008, boosting the market to $1.2 trillion from $727.6 billion, Bloomberg and Bank of America Merrill Lynch index data show. Relative yields on the notes have dropped to 475 basis points from as high as 2,182 basis points in December 2008.
When investment managers crowd into similar assets at the same time, especially those that aren’t frequently traded, the behavior may “create adverse market impacts if financial shocks trigger a reversal of the herding behavior,” the Treasury said in its report last week. Leverage can also increase the risk of systemic shock, it said.
At the same time, fund managers who are able to buy securities trading “significantly below their intrinsic values” could help stabilize price declines, according to the study.
The 21 primary dealers that do business with the Fed reduced their corporate-debt inventories by 76 percent through March from the peak in October 2007 as they faced higher capital requirements set by the 27-nation Basel Committee on Banking Supervision and risk-curbing rules laid out by the 2010 Dodd- Frank Act in the U.S.
Bank Leverage
The average ratio of tangible assets to tangible equity for the six-biggest U.S. banks, a measure of leverage, dropped to 12.8 in June from 27.5 at the end of 2007, Bloomberg data show.
When investors pull money for illogical reasons, “it’s as if we’re sitting at a poker table and a drunk businessman walks into the casino and sits at our table,” Steve Kuhn, whose Pine River Fixed Income Fund was the second-best performing hedge fund last year, said in a Bloomberg Television interview on Oct. 3. “That’s a good day for you, when people are making decisions for less than logical reasons, and you can sit there and calmly try to decide what true value is.”
While excesses in the market aren’t as troubling as they were before the financial crisis, “we’re going in that direction,” Oaktree Capital Management LP Chairman Howard Marks said in a Bloomberg Television interview on Sept. 7.
If Treasury yields rise high enough, people will rotate into the government debt and safer securities as they “wouldn’t have to take the pain of investing in low-quality instruments,” he said.
Yields on 10-year Treasuries rose as high as 2.99 percent on Sept. 5 from a record low of 1.38 percent on July 24, 2012. They’ve dropped to 2.65 percent after the Fed surprised investors on Sept. 18 by maintaining its monthly purchases.
The central bank will now take the first step in reducing its bond purchases in December, according to 59 percent of 41 economists in a Sept. 18-19 Bloomberg survey.
“The biggest potential threat is liquidity,” Joseph Engelhard, a former Treasury Department official who is now senior vice president at Capital Alpha Partners LLC in Washington, said in a telephone interview. “If all the hedge funds try to get out, who’s going to be buying?”
Elsewhere in credit markets, Neiman Marcus Group Inc. is planning to sell $1.56 billion of debt to help finance the luxury retailer’s buyout by Ares Management LLC and the Canada Pension Plan Investment Board. The cost to protect against losses on corporate bonds in the U.S. and Europe rose as U.S. lawmakers remained deadlocked on extending the nation’s debt limit to avoid a default by the world’s largest borrower.
Global Spreads
The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, climbed 1.3 basis points to 80.9 basis points as of 12:10 p.m. in New York, according to prices compiled by Bloomberg.
In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings increased 1 basis point to 98.1.
The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.
Bonds of Verizon Communications Inc. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.5 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The New York-based telephone carrier raised $49 billion on Sept. 11 in the largest corporate bond issue ever.
Dallas-based Neiman Marcus plans to sell $960 million of eight-year senior notes and $600 million of payment-in-kind toggle notes due in 2021, according to a filing with the U.S. Securities and Exchange Commission. Payment-in-kind borrowings allow the issuer to pay interest with additional debt.
Moody’s Investors Service assigned a Caa2 rating to Neiman Marcus’s planned notes and downgraded the company’s corporate family rating to B3 from B2, citing increased debt from financing the deal, the credit grader said today in a statement.
