Funds take advantage of evolving opportunities

New credit hedge funds continue to enter the market. At the same time, the opportunity set in the structured credit space is evolving.

One credit hedge fund manager suggests that a key factor in the influx of new funds is the "draconian conditions" imposed upon traders at investment banks. He points to a number of hedge funds that have essentially been spun-off and staffed by investment banks, funded with external capital and thus have side-stepped the regulatory issues around bonuses.

The market is not in danger of being overrun with credit hedge funds, however - not least because so many failed to survive through the crisis. The manager believes that the quality of hedge fund offerings has improved as a result.

"The crisis was a real flushing process. The funds that are launching now are generally being run by good quality teams," he explains.

Credit hedge funds are nonetheless repositioning themselves as market conditions change and spreads tighten. One structured credit investor says a number of opportunity sets are gaining traction at present.

He explains that more than two-thirds of his firm's portfolio has been in credit funds over the past couple of years. "The opportunities in that space have been great for the last two years and continue to be great, but in a different way now. We have to be more selective in deciding what to invest in and how to invest in credit. The long-biased credit opportunity set driven by spreads disappeared by mid-2010."

The investor says that one of the evolving opportunities for credit hedge funds is in ABS, CDOs and CLOs. As the broader market rallied, not all of these structured vehicles kept pace and so value can still be found in the way that they are pricing currently.

"Some subsets are more difficult to understand and are tainted by negative connotations. People are scared of them," the manager adds.

He continues: "Not all investors have the wherewithal and quantitative ability to disregard rating agencies' waterfall models. But those that can do so will find tremendous value in hard-to-understand assets, both in the US and in Europe."

A similar strategy can be adopted for MBS, especially in the US - though the investor warns that the end of quantitative easing, which is currently slated for June, could dampen the opportunity. He is confident that quantitative easing will continue, however.

"I believe it will be difficult for the government to bring an end to quantitative easing," he explains. "It might not be called QE3, but it will happen. Defaults are still occurring at an alarming rate, so the government will have to take some form of action."

Another evolving opportunity for credit hedge funds is to take advantage of the current refinancing wave. The manager says that one-third of his firm's exposures are in this segment.

"To succeed, it is crucial to know how to take advantage of what happens as and when refinancings occur. This is one opportunity set that is very heavy right now and should be rich for the next two or even three years, as the world adapts to a lack of growth caused by banks still trying to clean up their balance sheets," he concludes.

JL