Hedge funds' use of credit derivatives a concern

Inexperienced managers may be using CDS 'inappropriately,' Hennessee says

By Alistair Barr, MarketWatch
Oct 30, 2006
Source

SAN FRANCISCO (MarketWatch) -- Hedge funds that don't have much experience in the field may be using credit derivatives "inappropriately," industry advisory firm Hennessee Group LLC said on Monday.

Credit-default swaps, or CDS, are derivatives that provide insurance against a company going bankrupt. Investors pay an annual spread, or premium, in return for the promise of a payment in the event of bankruptcy or a similar credit event. As the creditworthiness of companies change, the cost of this insurance fluctuates.

CDS are a common investment and trading tool of credit hedge funds, which have used the derivatives effectively over the past five years, Hennessee, which tracks manager performance, said.

However, equity hedge funds have begun trading CDS more during the past year too, making Hennessee concerned that managers who are inexperienced in derivatives markets may be using them in inappropriate ways, the firm explained.

Equity funds have been using CDS in several ways. Instead of being used as a speculative investment, CDS have often been purchased to hedge portfolios of other securities that funds currently own, Hennessee said.

Some managers purchase CDS on corporate bonds designed to profit from a widening in corporate credit spreads.

Others buy CDS on sub-prime, mortgage-backed, fixed-income securities and indexes as a way to profit from deterioration in credit quality among mortgage borrowers.
Some managers also buy CDS on emerging-market government debt to bet on a decline in a country's credit quality, Hennessee noted.

"While there doesn't appear to be any imminent risks to the credit markets caused by hedge funds, we are concerned about the use of these instruments by funds that are not well-versed in how these markets trade and the dynamics of counter-party risk," Charles Gradante, managing principal of Hennessee, said in a statement.

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Alistair Barr is a reporter for MarketWatch in San Francisco.