SAC cuts back on its credit fixed income business. An interesting development when a savvy hedge fund manager decides to reduce exposure to credit risk businesses just when you think that there would be strong opportunities in this asset area, or maybe SAC is smarter than most and believes that these credit problems may need years to work out.
Gains in hedge fund are a function of profit opportunities and the efficient use of capital. Lower profits can be taken in a given market sector if liquidity is higher, the portfolio can be turned over more quickly and financing is available. In the case of fixed income credit plays, you have the worst of all three.
There is limited financing available from banks to buy bad credits. They have enough exposure to credit risk without providing lending for customer credit plays. Even if financing is available the financing cost is much higher than a year ago.
Liquidity is limited in the credit area so the bid-ask spreads are very large. The search costs of finding a buyer or seller are higher than in other markets because there are limited players who have the expertise to evaluate these securities. The potential for asymmetric information problems is great when the securities are hard to value. Clearly, there is little meaning to any rating on a asset-backed security. The stress testing from a few years ago may have less meaning in the current foreclosure-delinquency period.
The lack of buyers also means that you will have to hold credit risk instruments for longer time periods, so portfolio turn-over will be low. The return has to be higher because the holding period will be longer. In some case, the value may only be realized if held until maturity.
Credit risk trading in the fixed income market may be the arena only for insurance companies and banks that can buy and hold until maturity; consequently, this may not be a sector for hedge fund participation. Fixed income may not be a place to play until some of the current uncertainty is resolved.
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