October 30, 2006 – New York, NY – Hennessee Group LLC, an adviser to hedge fund investors, today notes that hedge funds have continued to increase their exposure to credit derivatives. According to a report issued by the International Swaps and Derivatives Association (ISDA) in September 2006, the total notional value of credit derivatives outstanding globally grew 52% in the first six months of 2006 to an estimated $26 trillion. However, Hennessee is concerned that many funds are inexperienced within the derivatives markets and may be using them in inappropriate ways.
“We believe that credit risk is being under-priced in the current environment, and credit derivatives are an effective instrument for hedge funds to mitigate credit risk within their portfolios,” said Charles Gradante, Managing Principal of the Hennessee Group LLC.
Hennessee notes that the use of credit default swaps (CDS) by credit-oriented hedge funds has been commonplace and effectively used over the past five years. However, it also notes that the use of CDS has become more prominent among long/short equity funds over the past year.
Equity funds have been using CDS in several ways, including: a) purchasing CDS on corporate bonds designed to profit from a widening in corporate credit spreads, b) purchasing CDS on sub-prime mortgage backed fixed income securities and indices intended to profit from deterioration in credit quality among mortgage borrowers, and c) purchasing CDS on emerging market government debt designed to profit from a decline in the country’s credit quality. Instead of being used as a speculative investment, CDS have often been purchased as a hedge to portfolios of securities that funds currently own.
“While there doesn’t appear to be any imminent risks to the credit markets caused by hedge funds, we are concerned about the use of these instruments by funds that are not well-versed in how these markets trade and the dynamics of counter-party risk,” noted Mr. Gradante.
Regulators have also noted the increased use of credit derivatives. The Federal Reserve last year requested dealers to improve their back-office systems for processing CDS following the bankruptcy of U.S. auto parts manufacturer Delphi. Since then, the back-office backlog has reportedly declined substantially. In addition, a study by Credit Derivatives Research LLC reported that credit default swaps based on the bonds of 30 takeover targets, including four of the five biggest LBOs of 2006, rose before deals were announced, increasing the interest of the SEC.
About the Hennessee Group LLC
Hennessee Group LLC is a Registered Investment Adviser that consults direct investors in hedge funds on asset allocation, manager selection, and ongoing monitoring of hedge fund managers. Hennessee Group LLC is not a tracker of hedge funds. The Hennessee Hedge Fund Indices® are for the sole purpose of benchmarking individual hedge fund manager performance. The Hennessee Group does not sell a hedge fund-of-funds product nor does it market individual hedge fund managers.
Description of Hennessee Hedge Fund Indices®
The Hennessee Hedge Fund Indices® are calculated from performance data supplied by a diversified group of over 1,000 hedge funds monitored by the Hennessee Group LLC. The Hennessee Hedge Fund Index is an equally weighted average of the funds in the Hennessee Hedge Fund Indices®. The funds in the Hennessee Hedge Fund Index are derived from the Hennessee Group’s database of over 3,500 hedge funds and are net of fees and unaudited. Past performance is no guarantee of future returns. ALL RIGHTS RESERVED. This material is for general information only and is not an offer or solicitation to buy or sell any security including any interest in a hedge fund.