LONDON Hedge fund managers who profited from a huge rally in credit since last summer are seeking ways to protect themselves against a sharp market sell-off if investor confidence evaporates.
Managers have been selling some bonds, increasing short positions or moving away from areas of the market more sensitive to a swing in sentiment, following a 38 percent drop since June in the iTraxx index, which measures the credit risk premium for a basket of high quality European bonds.
Many investors and managers of more traditional funds remain positive on the outlook for credit this year, after the European Bank pledged to do "whatever it takes" to support indebted euro zone countries.
That promise persuaded investors to pile into riskier assets but some hedge funds fear the rally has hidden stubborn problems like bad bank loans and the capacity of countries like Italy, which goes to the polls this weekend, to complete painful reforms.
"The market is so positive. Meanwhile, things are happening. There has been a lot of negative news from companies, problems are starting to come out," said Gennaro Pucci, founder of hedge fund firm PVE Capital.
"We want to see how the Italian election progresses. If Berlusconi comes back to power it will be a big disaster for the country."
His fund profited from long positions in the first half of January, but he has since sold bonds, bought 'out-of-the-money' options to protect against market falls and put on short positions on bonds in peripheral countries such as Italy.
Out-of-the-money options are those where the price at which the owner can exercise that right are below the current market price.
Pucci's shorts - bets on a lower price - include bets on tier one Italian bank bonds, as he believes there is not enough clarity on losses at ailing Banca Monte dei Paschi.
"We believe the losses from Monte dei Paschi can spread. If non-performing loans are rising in one bank, they could be seen spreading. We're looking at contagion risk, primarily in Italy," Pucci said.
While hedge funds have enjoyed the credit rally - funds betting on fixed income corporates gained nearly 10 percent between June and January - some worry about a sharp sell-off if investor sentiment - so bullish in recent months - turns sour.
Muzinich & Co hedge fund manager Jason Horowitz told Reuters he expects volatility to increase this year as money moves in and out of credit and said he has been buying "cheap protection" by shorting bonds of highly levered cyclical companies that have already rallied strongly.
And Sal Naro, founder of U.S.-based Coherence Capital and former co-managing partner at $4.8 billion fund firm Sailfish Capital, said he "significantly changed" his positions in January. He sold bonds and added short bets in the financial services and publishing sectors and Middle Eastern sovereigns, although he noted that spreads have widened in recent weeks.
Even hedge funds which still see bargains in Europe are sounding a cautious note.
Louis Gargour, CIO of hedge fund firm LNG Capital, said credit markets were "frothy, (but) not fundamentally flawed", adding some European corporate bonds are still "super-cheap".
However, he has been moving from high-yield bonds to bonds he think will be less influenced by investor mood, favoring the bonds of Spanish regions such as Madrid and Catalonia.
"Risk appetite will move high-yield," said Gargour. "Stressed companies and idiosyncratic stories are not influenced by the greater market but by the individual situations. More nimble investors should (stay) away from something that can be affected by general risk appetite."
(Editing by David Cowell)