A recent Risk magazine story by Kris Devasabai notes that hedge fund borrowing costs from prime brokers may increase due to higher bank regulatory capital requirements under Basel III.
One important effect of potentially higher funding costs is undermining the borrowing-dependent business model of fixed income hedge funds. As Devasabai explains,
In private, some bankers are talking tougher and warning some strategies may simply not work anymore, such as relative value fixed income, which relies heavily on borrowed money to generate big returns from small pricing discrepancies. ...
According to research from Barclays, the average hedge fund could see a drop in returns of around 10–20 basis points if financing rates for less liquid assets rise by 25–50bp.
Fixed income arbitrage funds – which have generated annualised returns of around 10% since 2009, according to BarclayHedge – would be hit hardest, with returns falling an estimated 40–80bp.
The problem with fewer fixed income hedge funds is that the liquidity of credit markets may decrease. This is because hedge funds account for a large portion of trading across a wide variety of fixed income assets, from corporate and government bonds to structured credit. As a Reuters story from 2012 noted:
U.S. hedge funds accounted for nearly a quarter of bond trading in the U.S. between April 2011 and April 2012, the most in five years and highlighting the greater presence of hedge funds in the U.S. bond industry . . .. Hedge funds generated 24 percent of the overall volume of fixed-income trading in the U.S. over the year period, a more than 30 percent increase from 18 percent in April 2011.
And fixed income trading hedge funds do not just contribute to the liquidity of bond markets. Indeed, the funds that trade bonds often trade stocks and thus contribute to their liquidity as well. An academic study by Petri Jylhä, Kalle Rinne, and Matti Suominen found evidence of fixed income funds often supplying liquidity in stock markets. The authors noted that
[o]ne of the main strategies of fixed income arbitrage funds is...so called “capital structure arbitrage,” where long/short positions in fixed income securities are hedged with balancing positions in the equity markets. Because of these equity linked strategies, at least, it is understandable that fixed income arbitrage funds act either as liquidity demanders or suppliers at NYSE and Amex.
Few may shed tears for fixed income arbitrageurs, as the Risk story notes. But if credit markets become less liquid, the negative impact on financing costs and price efficiency could be substantial. For over a decade, credit markets have been highly dependent on hedge funds, as a 2005 Fitch report makes clear.