Hedge funds are borrowing too much to finance their investments in credit derivatives, contracts based on debt, which may magnify volatility in a market downturn, according to a Fitch Ratings survey of 65 banks, insurers and money managers.

Hedge funds’ influence on credit derivatives and debt markets has continued to grow at a ‘dramatic pace,’ Fitch said in the report Tuesday. The funds are responsible for 60% of all trading in credit-default swaps and about 33% of collateralised debt obligations, securities that package debt, the ratings company said, citing data from Greenwich Associates.

US corporate bond risk premiums reached the highest in almost two years last week, as hedge funds bought credit-default swaps to offset potential losses from the subprime mortgage rout. Bear Stearns was forced to provide $1.6 billion for one of two funds that made wrong-way bets on subprime debt. The New York-based firm didn’t bail out lenders to the other fund, which borrowed against its investors’ capital to take bigger risks.

In a market slump, large deals financed with borrowed money, or leverage, may “result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side,” analysts led by Ian Linnell in London wrote in the report for the 2006 survey.

Banks and money managers bought and sold about $50 trillion of credit derivatives in 2006, more than twice the total in the previous year, Fitch said. The market has grown 15-fold since Fitch started the survey in 2003, the ratings company said.

“Until all of this recent volatility, investors had been forced down the credit quality ladder, and up in leverage to meet investment targets,” said Matt King, head of credit products strategy at Citigroup in London.

“Now it appears hedge funds are deleveraging” to meet demands from their lenders. Morgan Stanley was cited as the most frequent trader of the contracts, followed by Deutsche Bank, Goldman Sachs Group and JPMorgan Chase, Fitch said.

The top 10 firms accounted for 89% of credit derivatives bought and sold in 2006, up from 86% in the previous year, Fitch said. “For better or worse, counterparty concentration appears to remain a feature of this market,” Fitch analysts wrote.

Contracts based on the debt of General Motors, the largest US automaker, were the most frequently traded single-name credit-default swaps last year, Fitch said, followed by DaimlerChrysler, the world’s second-largest maker of luxury cars.

Investors put the most money into contracts on GM and the government of Brazil, Fitch said. Banks and hedge funds say it’s cheaper and easier to use credit-default swaps to speculate on the ability of companies to repay debt than trading the underlying securities.

In a credit-default swap, the buyer pays a premium to guard against a borrower failing to pay its debts. In the event of default, the buyer gets paid the full amount insured, and hands over defaulted loans or bonds to the swap seller. Swap prices decline when creditworthiness improves, and rise when it worsens.