Hedge funds with an insatiable demand for high-yield debt are spawning a new market for loan derivatives in a record year for lending to companies with junk ratings.

Credit-default swaps based on loans, which barely existed at the start of this year, have grown to $7 billion, according to data compiled by Lehman Brothers Holdings Inc. BlueMountain Capital, Cairn Capital Ltd. and CQS Management Ltd. are leading hedge funds using the contracts to speculate on the ability of companies to pay their bank debt. The market may quadruple in 12 months, Lehman estimates show.

Rising interest rates are making investors so hungry for loans that JPMorgan Chase & Co., Citigroup Inc. and Bank of America Corp., the three biggest American banks, can’t keep up. American company loans with ratings below Baa3 at Moody’s Investors Service and BBB- by Standard & Poor’s returned 3% in the last six months, beating the 2.5% for junk bonds, Lehman said.

“We’ve started using them when we haven’t been able to get our allocation of loans,'” said Mark Conway, a money manager at CQS, a hedge fund in London’s Belgravia district that oversees about $5 billion, including derivatives. Derivatives are financial instruments derived from stocks, bonds, loans, currencies and commodities, or linked to specific events like changes in the weather or interest rates.

Leveraged loans, credit for companies with junk ratings, increased by 20% in the U.S. to a record $374 billion so far this year, according to data compiled by Bloomberg. Kohlberg Kravis Roberts & Co. and Blackstone Group in New York and Washington, D.C.-based Carlyle Group are leading buyout firms in $305 billion of debt-financed purchases, up 20 percent from last year’s total.

The competition from investors for the highest yields is so great that borrowers are turning lenders away. Eircom Group Plc received offers of 15 billion euros ($19 billion) when it needed 3.65 billion euros this month to pay for its takeover by Babcock & Brown Capital Ltd.

The Dublin-based phone company could have raised “significantly more,” said Kristian Orssten, head of European lending in London at JPMorgan, which arranged the financing.

The credit pays interest ranging from 2 percentage points to 4.25 percentage points above the London Interbank offered rate, a benchmark used by banks to set borrowing rates. That compares with as little as 0.15 percentage point for investment-grade Siemens AG, Europe’s largest engineering company.

When investors can’t get the loans, they’re increasingly using credit-default swaps. Prices of these contracts fall as the perception of company’s ability to repay its debt improves. They rise when the outlook deteriorates. In the event of a default, sellers of the contracts must pay buyers the face value or the loan itself. Companies have no control over credit-default swaps because they are created and traded by financial firms.

Similar swaps for bonds started trading about 12 years ago.Lehman predicts trading of the loan derivatives may exceed the daily turnover of $1.5 billion in the loan market as soon as 2009.

BlueMountain, a New York-based hedge fund that oversees $2.8 billion, relied on credit-default swaps twice in the past month after it could buy only 25% of the $20 million it was seeking, said Jeff Kushner, a managing director.

“This could change the face of the loan market,” said Robert Reoch, who made one of the first-ever credit-default swap trades in 1994 to reduce risk at JPMorgan, and now is a credit derivatives consultant in London.”The old guard is gradually being replaced by a new breed.”

Hedge funds, unregistered pools of capital managing money for wealthy investors and institutions, need higher returns to maintain their fees.

The funds earned a record $16 billion last year, charging customers 1.44% of the assets they oversaw, data compiled by Chicago-based Hedge Fund Research Inc. show. The fees don’t include performance payments, which averaged 19.2% of investment profits in 2005.

Loans and the credit-default swaps based on them are growing more popular because central banks are raising interest rates. Forecasts for higher defaults by Moody’s and S&P also make bank debt more attractive because lenders usually get more money than bondholders if a borrower defaults. According to Moody’s, lenders recover about 78% of their money during bankruptcies, compared with 45% for bondholders.

Unlike bonds that pay fixed coupons, loan rates typically reset every three months. The London Interbank offered rate for debt in dollars has increased to 5.4% from 1.1% since the U.S. Federal Reserve began increasing its target for overnight lending in 2004.

Hedge funds that used credit-default swaps to speculate on $10 million of CableVision Systems Corp. loans in June and sold them now would have a profit of $60,000, according to Bloomberg calculations based on Lehman prices. That compares with a loss of about $50,000 on the same amount of loans in the same period, according to Lehman.

Investors were able to sell the credit-default swaps two months ago and get paid $145,000 a year. Now, similar contracts pay $130,000. Buyers of credit-default swaps, typically banks or insurers, agree to pay a fixed amount annually to sellers of the contracts. Prices for the Bethpage, New York-based company’s $6.7 billion of bank debt fell. CableVision’s $2.4 billion of loans due in 2012 dropped to 99.5 cents on the dollar from 100 cents in June, Lehman said.

Investors also profited on credit-default swaps related to Eastman Kodak Co. Speculators could sell derivatives based on the debt and receive annual payments of $180,000 in June. Now similar contracts would pay $150,000 a year.

The Rochester, NewYork-based company’s $2.7 billion loan maturing in 2013 was little changed during the same period. It pays interest of 2.25 percentage points more than Libor.

The swaps are also attracting managers of collateralized loan obligations, bonds backed by pools of hundreds of loans. Domestically, CLOs and hedge funds own more than two-thirds of leveraged bank debt, up from about half in 2000, according to S&P.

“We want to make more and lose less, and making use of the full tool kit will allow us to do that,” said Jack Yang, director of business development at Highland Capital Management LP, which manages $1.4 billion in CLOs. “We plan on using them, absolutely.”

Investors still prefer loans to derivatives because they allow them to participate in talks over restructurings or bankruptcy proceedings, said Zak Summerscale, who helps manage 4.25 billion euros of high-yield debt through CLOs at Babson Capital in London.

“The whole point of buying loans is that you get some control and a seat at the table, which allows you to negotiate early and at the right time,” Summerscale said.