Equity hedge funds’ appetite for credit derivatives grows

Hedge funds are increasingly willing to buy and sell credit protection, either as part of a more complex strategy, or outright, according to dealers.

Default swap volumes for trades with hedge funds seem to have doubled each month over the past year, said Eric Oberg, New York-based head of North American credit derivatives sales and marketing at Goldman Sachs.

Dealers in Europe tell a similar story. “During 2002 in particular, convertible players have found they can make larger returns through credit trading than they can through traditional convertible bond arbitrage,” said Martin Bates, London-based head of credit derivatives hedge fund sales at Morgan Stanley.

London-based hedge fund Zelengora Capital Management is taking a closer look at credit derivatives. Started in 1998, the fund primarily follows strategies that utilise both equity derivatives and convertible bonds. “We currently use assets swaps for convertible bond arbitrage,” said Zelengora’s investment manager, Raza Hussain. “But we are now carefully considering using credit default swaps,” he added.

The fund is considering using default swaps for hedging credit risk in convertible bond arbitrage, and also credit arbitrage and capital structure arbitrage. Hussain added: “We have a sufficiently flexible mandate so we can begin using default swaps when we feel the time is right.”

Capital arbitraging has begun to take off in Europe, and business is picking up as dealers pitch ideas to clients, said Bobby Console-Verma, London-based head of convertible strips at CreditTrade, an electronic credit trading platform.

A number of banks pitched an idea on France Telecom this month: hedge funds were encouraged to sell protection on France Telecom out to November 2004, while buying equity puts with the same maturity and a total cost as close to the net present value of default swap premium cashflows.

“This kind of trade allows investors to take a view on a company’s recovery rate and the future correlation between equity and credit spreads,” Verma said. “With the long credit/short equity position, the investor generates a profit if the credit spread and stock price remain below a certain level.”