According to an article in the March 21 edition of Pensions & Investments, hedge fund strategies focused on bonds such as relative value and long/short credit are facing increased liquidity risk due to unintended consequences of regulations such as Dodd-Frank and Basel III. This is especially true in the junk bond arena. The legislation closed the proprietary trading desks of the banks and increased capital reserve levels have caused a liquidity crunch. In the past, the proprietary trading desks were the primary trading counterparties for hedge funds. Some funds that have closed include Claren Road Asset Management, Third Avenue Focused Credit Fund, and Lutetium Capital.
Fund managers have responded in a variety of ways. They have traded in smaller amounts, reduced their leverage and expanded their counterparties. According to Aaron Dalrymple, head of credit at Cliffwater, smaller transactions of $5 million in capital are easier now. There has been some outreach to pension funds and endowments as new trading partners, either directly or through a dark pool in Liquidnet.
Until the liquidity issue is resolved, firms are scaling down or closing credit strategies. Investors have agreed. In the second half of 2015, alternative investment data provided eVestment stated that there was no demand for credit strategies.
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