Hedge funds' role grows in US fixed income, says Greenwich survey

Hedge funds generated nearly 30 per cent of all US fixed-income trading volume last year among participants, double the 15 per cent they accounted for during the previous 12-month period, according to a survey by Greenwich Associates.

Total trading volume among the 1,333 institutions participating in the 2007 North American Fixed-Income Investors Study increased 10 per cent to USD25 trillion last year, a slowdown from the 20-25 per cent increases seen in each of the previous three years but still significantly greater than the growth of around 7 per cent in fixed-income assets under management in institutional portfolios - an indication that institutions have been increasing the pace of their trading activity.

Over the 12-month period covered by the study, trading volume in distressed debt and leveraged loans more than doubled, while volume in below investment-grade bonds increased by some 40 per cent and volume in investment-grade credit bonds grew by more than 20 per cent.

That accelerated pace of trading was due at least partially to the ongoing advance of hedge funds in the US fixed-income market, the firm says. 'Fixed-income trading volume among hedge funds that interviewed in both 2006 and 2007 surged some 90 per cent,' says Greenwich consultant Tim Sangston.

In past years, Greenwich Associates has documented the rise of hedge funds from minor players to significant sources of liquidity in certain fixed-income products. However, the recent expansion of hedge fund positions and trading activity has been so rapid and consistent that it the firm says it is now no exaggeration to say that in 2006-07 hedge funds were no longer just an important part of the market in some fixed-income products, they were the market.

Hedge funds currently generate more than 55 per cent of US trading volume in liquid or 'flow' derivatives with investment-grade ratings, more than 80 per cent in high yield derivatives, more than 85 per cent of trading volume in distressed debt, nearly 55 per cent of volume in emerging market bonds and more than 40 per cent of US leveraged loan volume.

Even in the most liquid US fixed-income markets, hedge funds were expanding their presence last year. In US government bonds, hedge funds are now the second-largest source of trading volume after investment funds and their advisors, generating some 30 per cent of market volume.

They are also biggest source of trading volume in interest-rate derivatives, accounting for 30 per cent of the total, generate a quarter of US asset-backed securities volume and 20 per cent of volume in mortgage-backed securities.

'However, it is at the other end of the liquidity spectrum that hedge funds have become the biggest force,' says Greenwich consultant Frank Feenstra. 'In structured credit, hedge funds generated nearly half the trading volume reported in the US over the past 12 months.'

For long-only investment managers and other investors, the impact of hedge funds is not limited to illiquid products. A portfolio manager from a large investment manager is quoted by Greenwich as saying: 'The hedge fund community and all its capital are the driving force of the markets these days, affecting volatility, liquidity and access to bonds.'

While the proportion of US institutions trading fixed income electronically was essentially unchanged from 2006 to 2007 at about 55 per cent, e-trading volume has been increasing steadily in some products.

Total electronic trading volume was essentially unchanged on a matched sample basis over the past 12 months, but volume in several products increased sharply. 'Institutions that do trade fixed income electronically direct nearly 40 per cent of their total trading volume on average to e-trading systems,' says Greenwich consultant Woody Canaday.

The biggest growth occurred in the mortgage-backed securities market, where e-trading volume increased by 172 per cent. In this market, about 40 per cent of institutions trade electronically, and e-trading represents 56 per cent of total trading volume, up from 30 per cent in 2005-06. Growth was also strong in US Treasuries, where total e-trading volume increased 31 per cent.

Greenwich Associates specialises in providing benchmark information on best practices and market intelligence on overall trends. Based in Greenwich, Connecticut, with offices in London, Toronto, and Tokyo, the firm offers more than 100 research-based consulting programmes to more than 250 global financial-services companies.

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