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.