EVEN at the helm of one of London’s biggest and most lucrative hedge funds, Hugh Willis, co-founder of the credit specialist Blue Bay Asset Management, says his job is not glamorous.

“There has traditionally been little excitement around corporate debt markets,” he said. “It has been seen as the poor relation of equities. But people are beginning to realise that in a typical buyout there can be $4 of debt created for every $1 of equity invested.”

There is little doubt that the focus has been on equities in recent weeks. Stock markets are close to all-time highs with takeovers, buyouts – and rumours – fuelling a frenzy of share dealing.

Yet, even at the end of another week in the maelstrom of deal activity, the strength and reliability of the debt markets has become a worry, nagging away at the back of most traders’ minds.

One said: “Debt markets are a slippery problem. If you say you’re worried, you look like a real doom-monger in the middle of all the breaking deals. But everyone’s thinking about a bubble. I suppose nobody really [understands] the credit cycle, but we can all see the huge volumes going through. There must be a saturation point – and that will hobble deals.”

Sitting in his Pall Mall office in a green cardigan and open-necked shirt, Willis is proof that the times have been good in the credit business. Six years ago Willis – nicknamed Rik Mayall because of his resemblance to the comic actor – and his long-time colleague Mark Poole set up Blue Bay to invest in the credit markets, which were still undeveloped in those days. Since then Blue Bay has become one of London’s top 10 biggest hedge-fund houses, with £11 billion of assets under management.

Through its four hedge funds and five long-only funds, Blue Bay invests in fixed-income securities such as corporate bonds, as well as credit default swaps and distressed debt. Six months ago, Blue Bay floated on the London Stock Exchange in a move that valued the company at £571m and brought the two founders about £30m each. It is now worth almost £1 billion and is in the FTSE 250.

Although one of the first and biggest, Blue Bay is not alone. Many credit specialists are operating in London, feeding off the new appetite for debt at Britain’s biggest companies and the burgeoning private-equity houses.

The credit hedge funds have recently usurped banks as the primary holders of corporate debt, taking on debt the banks would probably seek to write off. According to Hedge Fund Research, funds that could specialise in distressed debt have assets of more than $250 billion (£126 billion) – five times as much as in 2000.

As one commentator said: “It’s hard to keep tabs on the credit funds. Suddenly, the debt structures have become so complex that it’s hard to tell what is debt and what is equity. Increasingly, it doesn’t matter because the hedge funds rule it all.”

The growth has created suspicions of hidden and misunderstood risks – both inside the credit hedge funds and on corporate balance sheets.

Theo Phanos, of Trafalgar Asset Management, the London credit hedge fund, said: “It is cheap for companies to borrow. But excesses are growing in the loan and corporate credit markets which can only lead to serious problems.

Willis, who has worked in credit markets for more than 20 years, says he is always vigilant, watching the markets for any change in the credit cycle.

“The European credit market is very young,” he said. The advent of the single currency in 1999 was the catalyst for the development of European fixed-income credit as a large new asset class. In the years that followed, investors burnt by equities when the dotcom bubble burst began to turn to fixed income. At the same time, European companies began to adopt a more American approach to leveraging their balance sheets to make them more efficient, a process that was accelerated by the rise of private-equity activity.

Willis said: “By 2000 it was obvious to Mark and me that European credit markets were going to take off and we founded Blue Bay to respond to this. Growth has been dramatic, aided by the fact that America has had a fully functioning corporate debt market for many years that has served as a model. There has been exponential growth – the European credit market is already more than 40% of the size of its American cousin and within five or six years it will be of a similar size.” Others agree there is plenty of capacity in credit markets and that the feared “saturation point” is misleading.

Phanos said: “There is plenty of capacity in the market. Hedge funds now account for more than 50% of the loan market, because they are more aggressive and will take better spreads than banks.”

Many chief executives are uncomfortable with the change in debt ownership. One FTSE 100 chief executive said: “If anything went wrong, we used to be able to call up the bank managers who had lent us the cash, go over and have a grown-up conversation. Now, because the banks syndicate all our debt, we haven’t a clue who owns it.”

Willis is unsympathetic: “Companies could instruct banks not to syndicate their loans – but they would have a tough time raising any money. The expertise of the distressed-debt specialists is crucial when things go wrong. These specialists can often save companies that would otherwise fail.”

So when will the credit cycle end? “There are four stages to the cycle,” said Willis. “The first, when spreads tighten dramatically, started in October 2002 and ended in late 2004. The second, which ended early this year, tends to be characterised by low volatility both at the index and the single credit level. The third stage, which we believe is just beginning in the current cycle, is one in which index volatility can remain low but single credit differentiation becomes more marked. The fourth and final stage tends to be one in which markets can become disorderly and credit failure can become briefly systemic. We do not see the catalysts in place for this fourth stage, but we remain vigilant.”

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