Borrowers would miss hedge fund liquidity if it left
Hedge funds have taken a lot of heat for their role in inflating order books and flexing spreads, only to flip out and take profits at the first opportunity. But despite the awkward and at times antagonistic presence of such funds, issuers are coming to learn that they are probably better off having them in the order book than not.
Hedge funds rightly receive a lot of criticism for their excessive orders. Over the past year, record order books became so commonplace that they scarcely warrant a mention.
At times, issuers' egos were inflated along with the order books, only to be deflated and bruised subsequently if trading in the secondary market failed to match expectations.
Most issuers have learned from that experience and reined in their trumpeting of overall demand for their deals, knowing that the size of the book tells onlookers little about the quality of the bid, instead often hiding it in a footnote.
These huge orders — inevitably slashed in allocations — can prove particularly disruptive in sovereign executions. As with any large investors, hedge funds can exert considerable leverage in controlling the final price outcome by threatening to drop out of a deal if they don’t believe it offers value. Either issuers cave, and pay an extra basis point or two for their deal, or they call the hedge funds’ bluff, knowing they have enough quality demand to allocate the size they want. That means allowing an order book to shrink substantially — which can itself cause volatility.
But issuers have also come to learn that if properly managed, hedge fund buyers can provide a vital link bridging a liquidity gap that, ever since the global financial crisis, market makers have been less willing and able to provide.
Lightly regulated hedge funds have the agility to deploy leverage and take bonds onto their balance sheets in a way that no other type of investor can. This can be particularly helpful during the crucial first hour of book building, when issuers are keen to show a strong and resounding response as a way to cajole other investors into getting behind their deal.
Early order momentum typically encourages the more hesitant and prized real money buyers to place their orders at a later stage, sometimes not until the final spread has been set.
Fast money orders are identified as such and their allocations are slashed by lead managers trying to ensure a balanced distribution, with just the right proportion of the volatile and liquid appetite that hedge funds and bank trading accounts bring to the table to offset the stable, constructive buy-and-hold accounts that receive the lion’s share.
This more hot-blooded component of demand may only amount to 10% of the allocation or less, despite sometimes constituting several times that proportion of the order book.
This balancing act — a key part of the syndication process — will undoubtedly become more nuanced as economic recoveries take hold and the ECB takes its long-awaited step back from QE.
Issuers may not always relish hedge funds’ contributions to their deal, but they play a vital role in primary and secondary markets. Issuers who understand this and court hedge funds successfully stand a much better chance of riding out a challenging year than those who don’t.