OFR Warns Of Risk From Credit Hedge Funds
Since the start of 2016, prices of equities and other risky assets have declined markedly. The proximate cause is an escalation of investor concerns about global growth and low oil prices. Global investors have been particularly sensitive to developments in China, due to its economic slowdown and the implications for global growth. As China’s authorities grapple with its downturn and record capital outflows, their August 2015 currency shift and more recent developments have fueled market concerns about the effectiveness of Chinese economic policies and communications. Meanwhile, oversupply in the oil market since mid-2014 has pushed prices to their lowest levels in more than 10 years, eroding the creditworthiness of U.S. energy producers and contributing to a broad repricing of U.S. corporate credit risk. In analysis by the Office of Financial Research (OFR), credit risk is elevated in the wider U.S. nonfinancial business sector, a potential financial stability threat discussed in OFR’s Financial Stability Report.
Developments since the November/December report
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- Commodity prices fell further amid evidence of growing oversupply in oil markets and further weakness in global demand.
- Uncertainty about China’s policymaking increased because of authorities’ acceptance of greater currency depreciation and the failure of market circuit breakers to contain sharp declines in local equity markets.
- Global equity and corporate credit markets sold off sharply, and declines in emerging market currencies accelerated.
- The Federal Reserve began increasing interest rates as expected in December. It raised the federal funds target range 25 basis points. Global growth concerns and falling inflation since then have reduced market expectations of further rate hikes in 2016.
- The Bank of Japan unexpectedly cut its interest r ate on excess reserves to negative 10 basis points in pursuit of its 2 percent inflation target.
China concerns resurged due to policy surprises, equity sell-offs, and record capital outflows.
Developments in China’s currency policy and equity market declines triggered a global retreat in risk sentiment in January. This retreat ended the period of stability in Chinese markets that prevailed since the shift in China’s currency policy last August (see the August Financial Markets Monitor). In January, market participants were again surprised as the People’s Bank of China signaled greater tolerance for faster depreciation of the renminbi by setting the USD-CNY fixing rate higher than the previous day’s close for successive sessions. The decision to let the currency weaken escalated concerns about the extent of China’s capital outflows and economic slowdown which drove a sharp sell-off in local equities (Figure 1). Newly established circuit breakers in Chinese equity indexes and the expiration of a six-month ban on company insiders selling shares exacerbated the selling at the start of the year. The circuit breakers were removed after twice halting trading. The insider share-selling ban was extended indefinitely. These policy reversals contributed to global investor fears about the effectiveness of Chinese policymaking.
Chinese foreign exchange reserves declined by more than $200 billion in the last two months.
Outflows for 2015 were about $500 billion, and were the first annual decline ever recorded. Total reserves are at their lowest since 2012 (Figure 2). The accelerating capital outflows bring a new challenge for Chinese policymakers, after years of strong capital inflows.
New evidence of supply-demand imbalance prompts further declines in oil prices.
Crude oil prices have declined 14 percent since the start of the year and reached their lowest levels since 2004.
Oil price volatility spiked to levels that last occurred during the global financial crisis (Figure 3). Market participants attributed the price action to further evidence of supply growth — the dominant factor in oil’s decline since mid-2014. In recent months, analysts raised their projections for production by the Organization of Petroleum Exporting Countries and U.S. oil inventories rose. Also, analysts are now expecting U.S. production to remain near their current high levels. Concerns also rose about weakening demand from China and emerging markets.
Developments in China and energy prices triggered broad-based declines across global financial markets.
Year to date, global equity markets have had pronounced declines. Major stock indices have declined more than 20 percent from their 52-week highs (Figure 4). Listed U.S. companies are being affected by low oil prices and slowing foreign growth. Weak energy sector earnings have been a drag on overall S&P 500 earnings growth, but earnings in many other sectors have also been less than robust.
Excluding energy firms, S&P 500 earnings in the fourth quarter of 2015 are estimated to grow only 1.5 percent. Earnings including energy are estimated to decline 5 percent. In comparison, overall S&P 500 earnings grew at a 5 percent compounded annual rate from the fourth quarter of 2010 through the fourth quarter of 2014. Equity valuations could remain under pressure due to weakening fundamentals, as discussed in the 2015 OFR brief, “Quicksilver Markets.”
U.S. corporate bond spreads rose to multiyear highs, pricing in greater default risks in the energy sector and higher probability of a default cycle in the broader corporate debt market (see the OFR’s 2015 Financial Stability Report). Although lower-rated and energy-linked spreads have widened the most, non-energy high-yield spreads widened to their highest levels since 2012 (Figure 5). The deterioration largely reflects the same energy and global growth factors affecting other markets. It also reflects the market reaction to the unusual suspension of investor withdrawals by a Third Avenue Management credit mutual fund.
Financial stress indexes surpassed levels of the August 2015 market sell-offs.
Since the beginning of the year, financial conditions have tightened and financial stress indexes have risen markedly (Figure 6). The most notable changes in the index components have been the increased volatility in oil markets, continued appreciation of the dollar, and the widening in high-yield credit spreads.
Emerging market assets remain under pressure.
Since the beginning of the year, emerging market currencies are 1.5 percent lower on average, led by 6-to-8 percent declines in commodity-sensitive currencies such as the Colombian peso, Russian ruble, and Mexican peso (Figure 7). Slowing growth and falling commodity prices continue to depress a broad set of emerging market asset prices. At the same time, idiosyncratic events have increased the political risk premium in countries such as Poland, South Africa, Turkey, and Brazil.
Hedge Funds Exposure to Credit Markets
(data as of September 30, 2015)
Reports in December of substantial investor redemptions at certain funds that manage high-yield credit portfolios intensified concerns about credit quality and market liquidity. The redemptions hit both mutual funds, notably Third Avenue Management’s Focused Credit Fund, and hedge funds, notably Stone Lion Capital Partners.1 These events highlighted the liquidity mismatch risks inherent in some asset management activities. Liquidity mismatch occurs when funds promise prompt, including daily, liquidity to investors while investing in relatively illiquid assets, such as certain high yield bonds and leveraged loans. It is important to note that the large majority of hedge funds, unlike mutual funds, do not offer daily redemption terms to investors.
In this feature, we examine hedge fund exposures to credit markets and the use of leverage by these funds, using non-public Form PF data.
OFR analysis shows that, not surprisingly, several individual hedge funds have material net long positions in credit markets. More importantly, several such funds are much larger and more highly leveraged than the funds noted above that recently had redemptions.
Credit market exposures data available for analysis in Form PF include long and short holdings of corporate bonds (including high-yield, investment grade, non-convertible, and convertible bonds), loans, and credit derivatives (single name credit default swaps [CDS], index CDS, and exotic CDS).
We limited our focus to the largest hedge funds, a group of more than 1,600 funds managed by advisors required to file Form PF quarterly.3 As of the third quarter of 2015, these hedge funds had a total long exposure of $777 billion, comprising $309 billion of bonds, $134 billion of loans, and $334 billion of credit derivatives (Figure 12). These positions were largely offset by short exposures totaling $506 billion, comprising $46 billion of bonds, $2.5 billion of loans, and $458 billion of credit derivatives. The net exposure, or the aggregate long minus the aggregate short position, was $271 billion (Figure 13).4 This exposure is relatively small compared to the overall U.S. corporate bond market ($8.2 trillion) and to the total gross assets of these hedge funds ($5 trillion).
However, several hedge funds had material net long positions. To better analyze this group, we segmented the Form PF hedge fund data into a smaller group of funds with net long exposures (based on corporate bond and loan positions) that approximate 50 percent or more of a fund’s net assets. We excluded any funds with net assets of less than $500 million.
This filter resulted in slightly more than 100 funds that manage approximately $180 billion in total net assets and $435 billion in total gross assets. These funds had a net long exposure to corporate bonds and loans of $188 billion and a net short exposure to credit derivatives of $17 billion. Overall, these funds had relatively low leverage. The median leverage ratio (gross assets divided by net assets) of 1.3 for the sample was below the overall median ratio of 1.9 for the broader universe of hedge funds. However, the 95th percentile leverage ratio for the sample was almost 5, and the five most leveraged funds in the sample had a simple average leverage ratio of 10.4.
In short, many of these credit-focused hedge funds are much larger and much more leveraged than comparable mutual funds that face regulatory restrictions on traditional balance sheet leverage and on the amount of illiquid assets held. Further, the combination of leverage and less liquid asset holdings may create vulnerabilities that can threaten financial stability.
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