Playing a bigger part
In general, there is more interest in fixed income hedge strategies than there has been for a while. The poor performance of some strategies, particularly long/short equity, has helped investors forget the problems during the 1998 Russian crisis, when expanding credit spreads caused problems for managers holding leveraged interest rate spread positions. Many (often highly leveraged) funds characterised these plays as arbitrage, when they could be more aptly described as directional trading of second order risk. The most public hedge fund problem in 1998 was the collapse of LTCM, the reverberations of which were felt in prime brokerage and governmental offices across the US and beyond. However, despite these high-profile losses, fixed income hedge fund strategies have returned an aggregated, annualised 9.8% since 1994.
Chris Mansi, who runs the hedge fund team at Watson Wyatt, says he advises his clients to invest through funds of funds, of which fixed income-based strategies are a valid part. “You have several different alpha generators and hope you don’t correlate too closely.” Other analysts say fixed income hedge fund strategies look increasingly attractive as the run in the fixed income markets starts to look mature.
Many fixed income strategies are quite market-neutral and so have low correlations with equities and bonds in normal conditions. Relative-value fixed income funds can be highly leveraged.
The fixed income arbitrageur aims to profit from price anomalies between related interest rate securities. Most managers trade globally, aiming for steady returns with low volatility. The category includes interest rate swap arbitrage, US and non-US government bond arbitrage, forward yield curve arbitrage, and mortgage-backed securities arbitrage. The mostly US mortgage-arbitrage managers exploit relative-value inefficiencies in mortgage-backed securities by buying and hedging undervalued assets.
Fixed income arbitrage has seen good inflows of assets as investors concerned about falling equity markets have sought exposure to strategies that have been under-funded for a significant period of time. This strategy had been relatively out of favour between mid-1998 and late 2001, but changes to the shape of yield curves then created opportunities for managers to exploit.
Convertible arbitrage involves the purchase and hedging of convertible bonds considered undervalued given their relationship to their underlying stock. A typical investment would be long the convertible bond and short the common stock of the same company. Positions are designed to generate profits from the fixed income security as well as the short sale of stock, while principal is protected from market moves.
Convertible arbitrage has seen huge inflows of capital over the past two years, supported by interest rate cuts, equity volatility and issuance tailored to hedge funds.
There are also managers specialising in distressed debt (whose aggregated index returns include equity plays; see table). Managers often buy the securities of a ‘distressed’ company (in need of legal action or restructuring), which are trading at a substantial discount to par value, when they expect a turn-around. Managers may also take arbitrage positions within a company’s capital structure, perhaps by buying a senior debt tier and short-selling common stock, hoping to realise returns from shifts in the spread between the two tiers.
An alternative way of looking at fixed income hedge funds to the diversified fund of funds is to take a traditional existing fixed income mandate and split it into its alpha and beta generation components. Daniel Beharall, manager of Henderson Investors fixed income hedge funds, explains: “The performance benchmark, if consisting purely of risk-free (government) bonds, is chosen to reflect the duration, dispersion and inflation-linked characteristics of the client liabilities. Any credit element to the benchmark reflects the client’s risk appetite. The outperformance target also represents a desire for return-enhancement, is also related to the client’s risk appetite, and is a reflection of a belief in active management (alpha generation).”
For example, a UK client might have a benchmark of 50% FTSE>15- year Gilts, 30% FTSE>5-year Index-Linked Gilts and 20% Merrill Lynch >15-Year UK Credit indices. The outperformance target may be 100bps and may be expected to be achieved through the active duration positioning and stock selection within each of the three subfunds, plus asset allocation versus benchmark between the subfunds.
The credit component partially matches liabilities and partially enhances yield. The index-linked component partially matches liabilities and partially inflation protects them, whilst each subfund gives the client active management potential.
Progressive managers and consultants are adapting their processes and products to match the disaggregation of duration, yield-enhancement and alpha generation to let a single manager concentrate on the area he knows best, and to diversify away from the home market benchmark. While a UK-specific benchmark matches the duration/liability element of client needs – sterling liabilities, fixed or inflation-linked, can only be hedged with sterling denominated and UK inflation-linked bonds – it serves little purpose beyond this, according to Beharall.
This portion of the portfolio for a UK client would include gilts/swaps to match the liability stream, perhaps with an index-linked bond component or RPI swap overlay as an inflation overlay.
Equally, when considering the yield-enhancement portion of the mandate, UK credit spreads might offer a closer hedge than overseas credit, but there might be better opportunities overseas, or better structured yield-enhancement techniques in the UK or overseas. A diversified satellite approach would include high-yield debt, emerging market debt, collateralised debt obligation equity and so on.
When it comes to alpha generation, “There is no logical reason,” says Beharall, “why alpha generated in the UK is of any different quality to that generated elsewhere, or that alpha generated by trading credit relative value is of any different quality to that generated trading government bond duration. On this subject, the quality of alpha as commonly measured using the Sharpe ratio, is more about who generates it than how or where.”
The benefits of the disaggregated core/satellite approach include minimal fee on the core fund, better diversification on the yield enhance portion, higher transparency and clear attribution of total returns, according to Beharall, who adds: “Most importantly, a higher risk-adjusted return should be achieved due to each performance element being efficiently rather than arbitrarily allocated.”
The question then becomes, what basket of strategies and managers should form the alpha generation portion? The answer depends to some extent on how much inherent return you believe exists in a particular style, in what range of market conditions that style can perform, and how much you attribute return to manager skill. Though Beharall is a strong believer in ‘manager skill’, and though the dispersion of manager returns within a style demonstrates its strong influence, academic work suggests that some styles have higher levels of inherent return than others. Convertible arbitrage managers make money by choosing from different subsets of inherent return – opportunities on one side or the other of volatility or interest rates, for example.