Hedge Funds Rush Into Debt Trading With $108 BillionLisa Abramowicz, Miles Weiss and Christine Harper
Hedge funds using debt-trading strategies honed on Wall Street are expanding at a record pace as they profit from risks big banks are no longer taking.
BlueCrest Capital Management LLP doubled its New York staff in the two years through December, while Pine River Capital Management LP increased its global workforce by one-third in
2012. Hedge-fund firms are hiring from companies such as Deutsche Bank AG, Barclays Plc and Bank of America Corp. as their credit funds have attracted $108 billion since 2009, data compiled by Chicago-based Hedge Fund Research Inc. show.
The flow of funds and people is taking place as regulators demand banks curb proprietary trading and back riskier wagers with more capital to prevent another financial crisis. That has allowed so-called shadow-banking firms to expand in businesses contracting at the largest lenders, including distressed-debt trading and fixed-income arbitrage, a strategy that seeks to profit from short-term price differentials.
“The regulatory posture in the U.S. and in Europe is unequivocal: They want to transfer risk to the shadow-banking system,” said Roy Smith, a finance professor at New York University’s Stern School of Business and former Goldman Sachs Group Inc. partner. “It does come at the cost of interfering with some financial capabilities of the large banks to function as market makers and arbitrage providers.”
Credit hedge funds, part of a less-regulated shadow-banking system that also includes money-market funds and real estate investment trusts, are still minnows compared with Wall Street’s largest lenders. BlueCrest, Pine River Capital and Millennium Management LLC, three of the fastest-growing funds, have combined assets of about $67.6 billion, according to people with knowledge of the matter. JPMorgan Chase & Co.’s corporate and investment bank had an average of $413.4 billion in trading assets in the first quarter, up 5.6 percent from a year earlier.
Still, debt-focused hedge funds are expanding rapidly. They attracted $41.4 billion from pension plans, wealthy individuals and other investors in 2012, the most since 2007, after a combined $57.4 billion of net inflows in the two previous years, HFR data show. The three-year total was a record.
Hedge funds focusing on fixed-income arbitrage boosted returns by 51 percent last year, while fixed-income, currencies and commodities-trading revenue at the nine largest banks rose 14 percent, excluding accounting charges, according to data compiled by Bloomberg.
The strategy, once employed by Long-Term Capital Management LP, focuses on exploiting pricing inconsistencies between assets rather than making bets on the market’s direction at a time when Berkshire Hathaway Inc. Chairman and CEO Warren Buffett and Goldman Sachs President Gary Cohn are predicting losses for fixed-income investors when interest rates rise.
Debt funds have received more inflows and swelled more than any other category since 2009 to include $639.7 billion of assets as of March 31, HFR data show. They have surpassed the size of equity-hedging strategies, which reported about $4 billion of redemptions in the period and now include $638.7 billion of assets, according to the data.
That growth also is attracting talent.
“There’s a continuous brain drain on Wall Street,” said Jason Rosiak, head of portfolio management at Newport Beach, California-based Pacific Asset Management, the Pacific Life Insurance Co. affiliate that oversees about $3.75 billion. “Hedge funds are playing in asset classes where they previously hadn’t played.”
Scott Martin and C.J. Lanktree, who ran a distressed-debt group at Deutsche Bank until last year, joined New York-based Solus Alternative Asset Management LP, where they’ve raised $1.1 billion for two funds that invest in bankruptcy claims.
Such claims are considered risky because they’re backed by companies that have already defaulted on their debt, are infrequently traded and are dependent on the outcome of legal disputes. Banks that decide to hold such investments would be required to have more equity to absorb potential losses compared with higher-rated securities, such as government debt.
“There are businesses based on our capital regulation we’ll not be able to do” that “hedge funds will be able to,” Deutsche Bank Chief Financial Officer Stefan Krause, 50, said at an April 25 conference in Berlin. “If I had to bet who is going to benefit the most post-crisis from the asset appreciation you have coming, then certainly hedge funds.”
James Staley, the JPMorgan executive who took over the firm’s investment bank in 2010 and was once seen as a candidate to become chief executive officer, quit in January to join $13.6 billion hedge-fund firm BlueMountain Capital Management LLC. BlueMountain was co-founded by Andrew Feldstein, who helped create the credit-derivatives market when he worked for JPMorgan in the 1990s.
BlueMountain reaped as much as $300 million from JPMorgan’s $6.2 billion trading loss last year by betting against the bank and then helping JPMorgan unwind its positions, people with knowledge of the matter said at the time.
BlueCrest, the London-based firm led by former JPMorgan trader Michael Platt, has hired more than 30 people for its New York-based team since 2010, while boosting its holdings by about $12 billion since then, to $36 billion, according to a person with knowledge of the matter who asked not to be named because the expansion hasn’t been publicly discussed.
The firm added at least three people from Deutsche Bank this year as it seeks to create what its website calls an “investment-bank quality” trading group. Hires included interest-rate derivatives trader William Yearick, mortgage-debt trader John Roach and distressed-credit analyst Matt Siravo, people with knowledge of the matter said at the time.
Last year, BlueCrest hired Eugene Gokhvat from Morgan Stanley and John McNiff, who was co-head of trading in commercial-mortgage securities at Bank of America.
Renee Calabro, a spokeswoman for Deutsche Bank, declined to comment, as did Kerrie McHugh at Bank of America.
Pine River, which hired Steve Kuhn in 2008 from Goldman Sachs to head fixed-income trading, has almost tripled its assets under management in the past 15 months, to $13.5 billion as of April 1 from $5.4 billion in January 2012.
Millennium expanded its staff by 32 percent to 1,250 people in 2012, adding Barclays trader Brian Maggio and Nomura Holdings Inc.’s Markus Weber, while increasing its assets by 25 percent, to $16.9 billion as of Dec. 31, regulatory filings show. Some of its hires this year include interest-rates derivatives trader Markus Meister from Deutsche Bank and UBS AG’s Preben Ramm.
The New York-based firm, run by Israel “Izzy” Englander, accelerated its expansion into fixed income in October 2008, when it hired Michael Gelband, a former global head of capital markets at Lehman Brothers Holdings Inc., less than a month after that company collapsed. Millennium Partners LP, the multistrategy fund that the firm uses to invest all of its $18 billion in net assets, formed a Cayman Islands subsidiary in June 2010 called Millennium Fixed Income Ltd.
Tripp Kyle, a spokesman for Millennium, declined to comment about the expansion, as did Patrick Clifford, who represents Pine River in New York, and Ed Orlebar for BlueCrest.
Bankers and traders are departing as average investment-banking salaries fell 14 percent last year compared with a 3 percent decline in salaries at alternative-asset managers, according to eFinancialCareers.com. They’re seeking to deploy skills learned at the biggest banks to capture business that those same firms now can’t afford to maintain.
“Business strategies are moving out of the banks and into the hedge funds,” said Constance Melrose, managing director of eFinancialCareers.com in the Americas. “You do need some of the people to deliver those strategies, and you have the opportunities to get those people.”
One of those opportunities is in bankruptcy claims and other forms of distressed debt. O’Malley Hayes, who sourced and traded illiquid loans at Bank of America, departed in 2010 to become a principal at Bayside Capital, an affiliate of H.I.G. Capital, a $12 billion private investment firm.
Fixed-income arbitrage business also is flowing to hedge-fund managers from banks poised to lose $17 billion of revenue in fixed income, currencies and commodities by 2016 because of levies and regulation, according to an April 22 report by Deutsche Bank analysts.
“We’ve seen some banks publicly pull back from activities that would require them to commit their balance sheet in a big way to fixed income,” said Shubh Saumya, a New York-based partner at Boston Consulting Group. “A hedge-fund balance sheet is a different type of balance sheet.”
UBS, Switzerland’s largest bank, said in October that it plans to cut 10,000 jobs and exit some of the most capital-intensive trading businesses, chopping about 80 billion Swiss francs ($85 billion) from the 110 billion francs of risk-weighted assets in its fixed-income business.
Firms including Millennium and BlueCrest reported an increase last year in what are known as regulatory assets under management, signaling an increase in fixed-income arbitrage strategies that usually use borrowed money and repurchase agreements to boost returns.
Because fixed-income arbitrage involves buying some bonds and betting against others through short sales, practitioners enter into reverse repurchase agreements to obtain securities they need to sell short. One example: If Japanese sovereign debt has higher yields relative to Treasuries than historically has been the case, a fixed-income arbitrage trader might buy the Japanese bonds and sell short U.S. government debt to profit when the spreads between the two reverted to customary levels.
Under a methodology developed by the U.S. Securities and Exchange Commission, these reverse repurchase agreements are counted as assets, even though the related short positions help offset risk. As a result, fixed-income arbitrage can cause regulatory assets under management to balloon. The measure differs from net assets under management, the industry standard.
At Millennium, the firm’s regulatory assets under management soared 67 percent last year to $198.2 billion from $119 billion, while its net assets under management increased about 25 percent to $16.9 billion, according to filings. BlueCrest’s regulatory assets jumped 50 percent to $95.4 billion last year, while its net assets under management rose 15 percent to $35.3 billion, filings show.
Firms such as Millennium guide traders to shorter-term strategies traditionally dominated by big banks, which cut corporate-bond holdings 76 percent since the 2007 peak, to $56 billion on March 27, Federal Reserve data show.
Fixed-income arbitrage strategies are benefiting from “a relative lack of competition from large banks,” Aetos Capital LLC, which invests in hedge funds, said in an April 8 SEC filing. The New York-based firm said its Aetos Capital Multi-Strategy Arbitrage Fund LLC had a 9.2 percent return for the 12 months ended Jan. 31.
One reason for the retreat is the 2010 Dodd-Frank Act’s Volcker rule, which seeks to curb so-called proprietary trading, or betting with a lender’s own money.
As primary dealers, most large banks made markets in government and corporate bonds and also carried inventories of securities. The market-making function gave them insight into trading patterns by institutional customers, allowing them to spot and sometimes capitalize on anomalies in the pricing of bonds. Banks also formed proprietary-trading desks that used their own capital to make similar wagers. Because pricing discrepancies were often small, the firms used leverage, or borrowed money, to generate higher profits, expanding the size of their balance sheets in the process.
“These large players provided the grease to allow the fixed-income markets to work,” said Brad Hintz, a former Morgan Stanley executive who now works as a bank analyst at Sanford C. Bernstein & Co. in New York. “The price of them doing that was they were taking risk.”
While the Volcker rule hasn’t taken effect because regulators are still working out details, some banks have already closed proprietary trading desks. Hedge funds, because they aren’t subject to the rule or to capital requirements, can take on the risk, increasing potential returns.
The move of fixed-income trading strategies to hedge funds could pose a risk to the financial system, according to Fed Governor Daniel K. Tarullo. He warned in a May 3 speech that regulators haven’t adequately addressed the dependence of some banks and other financial companies on short-term, borrowed money that can dry up quickly in a crisis, which contributed to the 2008 collapses of Bear Stearns Cos. and Lehman Brothers. Cracking down on such market funding only at banks could push those businesses elsewhere, he said.
“The regulatory change should apply whether the borrower is a commercial bank, broker-dealer, agency Real Estate Investment Trust (REIT), or hedge fund,” Tarullo said.
Pine River’s $3.9 billion Fixed Income Fund posted a 35 percent return last year, the most among 15 hedge funds focused on debt-arbitrage strategies, according to HSBC Holdings Plc data. Millennium Partners has returned 3.41 percent this year through April 18, HSBC data show. BlueCrest’s $1.6 billion Multi-Strategy Credit fund gained 4.7 percent this year through April 30, a person familiar with the returns said.
The Solus Recovery Fund, which has investments in claims from the Lehman Brothers and MF Global Holdings Ltd. bankruptcies, returned 17.8 percent in the 13 months ended March 29, according to an investor letter obtained by Bloomberg News.
“As a general matter, any time you have a big financial crisis like Long-Term Capital in 1998 or the recession of 2008, fixed-income arbitrage usually gets hurt during the crisis and has very good returns afterwards,” said Anne Casscells, chief investment officer of Aetos Capital’s absolute-return strategies. “What is different between now and 1998, is that now the banks are under regulatory pressure not to return to proprietary trading or even positioning.”
Long-Term Capital Management, one of the world’s biggest hedge funds at the time, lost more than $4 billion, mostly as a result of a highly leveraged fixed-income arbitrage strategy, after a debt default by Russia. It required a bailout by banks overseen by the Fed.
Profitability at the biggest banks has declined as regulators globally sought to fortify the financial system after the mortgage-debt crisis resulted in $2 trillion of writedowns and credit losses after June 2007. The average return on equity at Wall Street firms fell to a range of 10 percent to 13 percent in 2012, from 15 percent to 20 percent before 2008, according to a Boston Consulting Group study released April 30.
Hedge-fund firms also are benefiting from demand by investors seeking relief from a fifth year of benchmark borrowing costs held at about zero in the U.S., the world’s biggest economy.
The Fed has funneled more than $2.5 trillion into the financial system since 2008 to help galvanize a global economy that economists expect will grow 2.28 percent this year, slower than the 2.32 percent annual average since 2005, Bloomberg data show. Japan’s central bank pledged to double that nation’s monetary base by the end of 2014 with more asset purchases.
Yields on company debt globally dropped to an unprecedented low of 3.09 percent on May 2, according to Bank of America Merrill Lynch index data. Credit hedge funds received $9.4 billion of deposits during the first three months of 2013, HFR data show.
Alternative-asset managers say they are enforcing risk-management measures as they expand. Traders at BlueCrest face having their capital allocations cut in half if they lose 3 percent of the money under their management, according to a person with knowledge of the matter. If their portfolio drops a further 3 percent, the trader will lose his allocation and possibly his job, the person said.
Millennium has 145 teams of traders who run their own strategies under risk guidelines set by the firm, according to a person with knowledge of the company.
Rule makers have been crafting legislation with the idea of enabling “risk to transfer itself into the so-called shadow-banking community, where it would be put into relatively small repositories that will be relatively insignificant if they fail,” said NYU’s Smith. If these hedge-fund firms fail, he said, “the real question is, to what degree will the market suffer from it.”