Credit Congress 2002: Credit hedging by convertible hedge funds set to rise, says Goldman

The potential opportunities for convertible hedge fund arbitrage will see the market grow from $2 to $2.5 billion by the end of this year, according to Klaus Toft, an executive director in Goldman Sachs’ credit derivatives strategies group.

Speaking at Credit Congress 2002, a conference organised by RiskNews' sister publication Credit, Toft said: “Everyone is excited about using credit derivatives. They are a tool that facilitate the isolation and management of credit risk from all other components of risk.”

The key advantages for investors in targeting the market are the ability to enhance yield, access to unavailable credit products and the customisation of exposures, Toft told delegates. He added that hedge funds were in a perfect position to take advantage of these opportunities.

A year ago it seemed that improving equity markets would curtail the role of hedge funds in the convertibles market. But Toft said hedge funds are now leading the market’s expansion as they become more interested in credit to undertake event arbitrage and relative value opportunities.

“Hedge funds exposure has skyrocketed,” he said. “And volatility and structural inefficiencies in the credit markets has created ongoing opportunities to add value.

“With busted convertibles there is no equity volatility and they behave more like a credit instrument, so demand for credit protection will increase as hedge funds look to hedge credit risk. From a technical standpoint, this leads to arbitrage and relative value opportunities.”

Opportunities should also rise as the market matures. “Credit markets have developed in size and sophistication since the advent of the euro. But there is still not very good transparency in the markets, and liquidity is a problem,” said Toft. But standardisation has already removed some uncertainty from the market and replaced that with liquidity, he added.

Toft believes the credit derivatives market shows remarkable growth potential. Credit derivatives represent only 5% of the $30 trillion corporate bond market, whereas interest rate swaps are 266% of an $18 trillion government bond. “Credit has the potential to show a twenty, thirty, even forty percent rise in annual growth rate,” said Toft. “But it will never reach multiples as the euro market is too fragmented.”