Hedge-fund troubles

Filed in archive Companies and Markets on May 11, 2005

Pressure on investors such as hedge funds and Wall Street dealers to cut losses or reprice their positions. Speculation of hedge-fund troubles dogged the credit markets throughout Tuesday`s trading session.

Collateralized-debt obligations, or CDOs, and credit-default swaps. CDOs typically are repackaged corporate debt with varying yields and levels of corporate risk. Investors can opt for CDO slices ranging from investment-grade corporate debt to unrated, extremely risky debt. Credit-default swaps are essentially products that provide insurance against a potential corporate debt failure

The Dow Jones CDX index of investment-grade credit-default swaps yesterday widened to 72 basis points, or 0.72 percentage point, from 63.25 basis points Monday, according to GFI Group. The European iTraxx indexes also came under selling pressure in the afternoon. The high-yield crossover index took the biggest hit, widening 25 basis points against a key benchmark to 380 to 385. Widening spreads reflect a flight to safety and away from riskier investments, such as corporate debt
The mayhem marks a substantial test for complex credit-derivative products, many of which involve leverage, or borrowed money. Thus small moves in the value of an underlying security can have a big impact on the value of such credit derivatives. Since these aren't listed on any market, closing out a position can be very costly.

Another problem area has been convertible bonds, which pay an interest rate, like any other bond, but allow holders to convert them to stock from the issuer at a preset price. By some analyst estimates, hedge funds own more than 75% of all convertible bonds on the market. Hedge funds normaly sell calls or short stock aginst these postions.In risk terms This is Selling into naked puts.

Average hedge fund`s have dropped about 1.8% in April, according to Hennessee Group LLC, Over all, returns are down 1.6% for the year.