Hedge Fund Reader : Hedge Funds can affect credit market adversely

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July 27, 2005

Hedge Funds can affect credit market adversely

Fitch Ratings recently raised concerns about the effect that hedge funds are having or are capable of having on the credit market. Though the funds are a major source of capital for the market and can promote liquidity in order to diffuse credit risk, they can spell trouble also. For example if several hedge funds decide to sell their holdings at the same time in order to reduce exposure to the market and meet margin calls, this could have severe implications on the credit markets. Such a scenario did somewhat emerge in May this year when General Motors and Ford Motor were downgraded to junk status. Hedge funds were seen to borrow almost 10 times their cash, using the leverage to control a larger amount of assets. Fitch ratings fear that in an unfavorable market scenario, hedge funds may be forced to sell their holdings in order to repay lenders. This might exaggerate the fall in price of the company credit on which the funds were betting. Also, since hedge funds have more or less narrowed down the distances between unrelated sectors, they might also trigger a cross segmental price decline of credit markets. IHT.com reports:

“Fears over hedge fund losses flooded through the credit markets early in May after the U.S. auto giants General Motors and Ford Motor were downgraded to junk status more quickly than many had expected.”

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July 27, 2005 in Research | Permalink