Bank bonds are likely to come under more pressure as investors react to a swell of rumors about bond hedge funds liquidating their assets.
Bank bonds recovered slightly Friday after a thrashing Thursday, but observers said investors are likely to stay on the sidelines until fears about the secretive hedge fund industry dissipate.
There is no way of telling whether there are other hedge funds out there that could be on the brink of disaster, said bank bond analyst Stanley T. August of First Union Capital Markets. "There could be more," he said "We don't know how leveraged these hedge funds are. Not knowing has made people more cautious."
Hedge funds moved onto center stage Sept. 25, when the bailout of Long- Term Capital Management LP was announced.
Investors are worried that hedge funds will be forced to flood the market with securities, said Merrill Lynch analyst Matthew Burnell. "Broadly you will see investors of all types in the fourth quarter trying to position their portfolios for 1999," said Mr. Burnell. "This will likely mean additional supply in the market, which potentially will drive spreads wider."
Bank bond spreads-the gap between their yields and the yield on Treasuries-widened by as much as 30 basis points Thursday, on a rumor that Eagle Capital Management, a bond hedge fund in Minneapolis was liquidating its assets because it was unable to make its margin calls.
Eagle President Paul Upcraft told Reuters late Thursday that the "rumors were wildly exaggerated and completely incorrect." He did not return American Banker's calls.
Nevertheless, rumors persisted. The fund is said to have amassed between $2 billion and $3 billion of assets largely with borrowed money.
Some hedge funds leverage their portfolios by getting financing from banks or brokerages in order to buy more bonds or other securities. A leveraged portfolio often leads to better return. But if the fund's securities lose value, the lender is likely to ask for more collateral. Hedge funds get in trouble when they are unable to meet that requirement.
That is what sources said is happening to Eagle Capital Management.
Lenders to the hedge fund-said to be Salomon Brothers, Lehman Brothers Inc., Merrill Lynch and Bear Stearns-got spooked by the softening in the bond market and asked for some assurances, sources said. Salomon Brothers, Lehman Brothers Inc., Merrill Lynch and Bear Stearns declined to comment.
Eagle is said to have put up $2 billion of securities for sale last week. "I have not seen a large bid list for that amount, but that means nothing. A hedge fund that does not want people to know that it is liquidating its assets can break it up an sell it to different brokers" in a practice known as "bearding," said Steven Bohlin of Thornburg Managers, which handles $1.8 billion in fixed-income securities.
Market experts said the rumor mill on more bond hedge funds liquidating has gone into overdrive and is likely to further harm the already deteriorating market.
"As long as we are in a bear market there will continue to be rumors," said bank bond analyst Michael Leit of Prudential Securities Inc. However, he said the climate now is similar to that in 1994, when some feared a meltdown in derivatives.
"Usually the end of panics are marked by some big guys going out of business. That's what we saw with the Orange County crisis. When a major fund dumps securities it is like a cleansing."