Thursday, October 20, 2005


Hedge Funds Load Up On Junk Loans

As Business Week reports, hedge funds are playing with dynamite. " As commercial banks back away from making corporate loans, a new breed of lender is stepping in: Hedge funds are providing hundreds of millions of dollars to companies whose shaky credit disqualifies them for prime bank loans or whose needs are too puny to attract big commercial bankers."

"Bank of America Corp. slashed its corporate loan portfolio from $110 billion in 2000 to $34 billion in 2004. For certain borrowers, hedge funds and other investment outfits not normally thought of as lenders are filling the gap."

"Hedge funds and other institutional investors now provide almost 50% of the $509 billion market for riskier, high-interest rate loans to corporations. That's up from less than 20% in 2000."

"One potential peril is that hedge funds will try to lure borrowers with relatively low rates, easy terms, and lax attention to creditworthiness. With barely any government oversight, fund managers inexperienced in lending may misjudge their borrowers. As a result, hedge fund investors ranging from public pension funds to wealthy individuals could face large losses."

"'You cannot have ever-riskier transactions and not ultimately have repercussions,' says Neal Schweitzer, of Moody's Investors Service Corporate Finance Group. Overall conditions in the high-yield debt world are already growing more worrisome. In the third quarter, only 41% of the ratings changes Moody's issued for high-yield paper were upgrades—down from 57% in the second quarter. Default rates are ticking up."

"Hedge funds are notorious for sometimes betting against the very companies whose securities they hold. Funds that buy the bonds of a struggling company, a bet that the issuer will recover, commonly hedge by simultaneously shorting the company's stock, an investment that pays off if the share price falls."

"Many loans made by new-breed lenders are quickly sold off, and hedge-fund money is fueling more intense trading in this secondary market. Trading of high-yield loans has increased from roughly $112 billion in 2002 to about $163 billion in the last 12 months. Loan prices have skyrocketed as new money has poured into the market. Nearly 50% of high-yield loans are priced above their face value, up from less than 2% in 2003."

"In addition to the fear that hedge funds will be tempted to make reckless loans that could go sour when the economy slows, some observers worry that eventually the funds will simply lose interest in lending and buying loans. 'Let's face it: The economy will change someday, and all these hedge funds will decide that there is someplace else they would rather be,' says Darvin Pierce, of Van Kampen Senior Loan Group, which manages about $6 billion in prime bank loan funds for individual investors."

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