The already considerable influence of hedge funds in US fixed-income markets increased last year as hedge fund trading volume soared between Q1 2005 and Q1 2006, according to new research.
Overall US fixed-income trading volumes - including bonds and derivatives - increased by about 25% in the 12-months covered in Greenwich Associates' 2006 Fixed-Income Investors Study. Over the same period, hedge fund trading volume in the same products more than doubled.
'As a result of their significant increase in fixed-income trading volume last year, hedge funds now represent an even bigger portion of the overall market,' says Greenwich Associates consultant Tim Sangston. 'In several individual products, hedge funds provide so much liquidity that one could say that certain markets could not function efficiently without them. For example, hedge funds now generate 45% of annual trading volume in emerging market bonds, 47% of annual volume in distressed debt, about one-third in leveraged loans and one-quarter high-yield bonds.'
While hedge funds are increasing their profile across U.S. fixed income as a whole, nowhere is their influence greater than in the increasingly important market for credit derivatives - a natural area of hedge fund emphasis given the leverage inherent in the nature of these instruments and the push by hedge funds away from more commoditized products and into areas with higher margins. In the past year, hedge funds accounted for more than 55% of all credit derivatives trading volume, including 60% of total volume in highly liquid 'flow' derivatives and a third of volume in structured derivatives products.
The Good and the Bad
As a result of these gains in derivatives and other fixed-income products, hedge funds are getting more attention from dealers than they ever have in the past. 'In many ways, they have become the market,' notes Greenwich Associates consultant Peter D'Amario.
From the dealers' perspective, the new sway of hedge funds comes with many positives. By their nature, hedge funds encourage the sell side toward innovation, especially when it comes to developing products spanning asset classes. The recent proliferation of CDO-type products and structured credit derivatives can be attributed in no small part to the demand by hedge funds for more sophisticated products. The perceived needs of hedge funds also figured heavily in the decision by some major investment banks to remake their research departments, with some drastically cutting back on written research and instead positioning desk analysts alongside traders to feed ideas into top hedge fund clients.
But there are negatives as well to hedge fund dominance. 'At the most obvious level, hedge funds are attracting a huge portion of sell-side attention and resources - so much so that many real money managers or institutions with relatively small annual trading volumes have seen their dealer coverage diminish,' says Greenwich Associates consultant Woody Canaday. 'In addition, there is the belief widely held among institutional investors and many other observers that hedge funds are increasing systemic risk throughout financial markets in general.'
From the point of view of the hedge funds, the biggest positive in the new order is that it has emerged mainly to cater to their needs. One practical result is that hedge funds, especially the biggest ones, often get the best ideas, first. That does not mean that hedge funds are not concerned about the new dynamic, in particular the proliferation of hedge-fund-like platforms among buy-side and sell-side organizations. Indeed, the proportion of real money managers with their own, in-house hedge fund platforms tripled to nearly 15% from 2005 to 2006. 'Institutions are quite open to new options that would allow them to generate additional alpha from this part of their portfolio without increasing volatility,' says Greenwich Associates consultant Dev Clifford. 'Many of the biggest US fixed-income managers are looking to capitalize on this willingness to experiment by offering their clients the option of hedge-fund-like accounts.'
A comparable situation among dealers has the potential for conflict on several levels. 'Sell-side firms want to cover hedge funds more actively, but at the same time some dealers are looking and acting more like hedge funds themselves,' says Greenwich Associates Hedge Fund Specialist Karan Sampson. 'While there has obviously been a strategic shift on the part of several major brokers in favor of hedge fund-like client options and proprietary trading, some dealers might also be feeling pressured to move in this direction simply to hang on to the talented individuals they have in their own organizations who otherwise might tempted to venture out and start hedge funds of their own.'