The number of hedge funds using debt trading strategy is set to grow at an unprecedented rate.

In a recent report published by Bloomberg, hedge funds are expanding their debt trading strategy as they profit from risks big banks are no longer taking.

Hedge Funds

Sensing the opportunity, Blue Crest Capital Management has doubled its number of staff at New York, while Pine River Capital Management LP increased its global workforce by one-third in 2012.

According to Chicago-based Hedge Fund Research data, debt funds have overtaken the size of equity-hedging strategies with the former accumulating $639.7 billion since 2009, while the latter has $638.7 billion of assets. The funds flow is accentuated with regulators demanding banks curb proprietary trading and buttress riskier wagers with more capital to prevent another financial crisis.

Credit hedge funds, part of a less-regulated shadow-banking system, are still minnows compared with Wall Street’s largest lenders. According to data compiled by Hedge Fund Research, debt-focused hedge funds garnered $41.4 billion from pension plans, wealthy individuals and other investors in 2012, the most since 2007.

According to Bloomberg data, hedge funds focusing on fixed-income arbitrage boosted returns by 51 percent last year, while fixed-income, currencies and commodities-trading revenue at the nine largest banks rose 14 percent, excluding accounting charges.

Interestingly, several external factors are aiding the growth of credit hedge funds. For instance last year, average investment-banking salaries fell 14 percent compared with a 3 percent drop in salaries at alternative-asset managers. Similarly under a methodology developed by the SEC, fixed-income arbitrage can cause regulatory assets under management to balloon.

Further, fixed-income arbitrage strategies are benefiting from a relative lack of competition from large banks. Banks are under regulatory pressure not to return to proprietary trading or even positioning.  While the Volcker rule hasn’t taken effect because regulators are still working out details, some banks have already closed proprietary trading desks. Hedge funds, because they aren’t subject to the rule or to capital requirements, can take on the risk, increasing potential returns.

The Fed has funneled more than $2.5 trillion into the financial system since 2008 to help galvanize a global economy. According to HFR data, credit hedge funds garnered $9.4 billion in deposits during the first three months of 2013.

Despite several factors aiding their growth, the alternative-asset managers are strictly pursuing their risk management strategies. For instance, Millennium has 145 teams of traders who run their own strategies under risk guidelines set by the firm.