Fixed Income: A Strategy Misjudged?

A new look at fixed income hedge fund investing

Sanjay Joshi and Rabbani Wahhab, London and Capital
Originally published in the April 2006 issue

The fixed income hedge fund universe is seen by many as a homogenous asset class that delivers low returns during periods of rising interest rates. However, in reality this asset class has within it a myriad of strategies that react differently to the interest rate and economic cycle and as a consequence carry little inter-correlation. In our opinion both investors and hedge fund managers need to adopt a more flexible approach towards fixed income hedge funds.

Investors seek and expect high alpha and high Sharpe ratios from hedge funds, but over the past couple of years they have felt that the fixed income hedge fund universe, with notable exceptions, has failed to deliver on these two fronts. Not surprisingly, investor confidence has been further eroded by the focus on central bank efforts to remove global liquidity and the feeling that this would have an adverse impact on bond markets. The perception is that in a period of rising interest rates and low volatility, fixed income strategies will languish and allocation to these must be reduced. However, we feel that this is a misnomer.

Nevertheless, misnomer or not, the perception has been sufficient for a significant migration out of fixed income hedge funds into strategies that conventional wisdom considers to be direct leveraged plays on the global economic and interest rate cycle. Additionally, many commentators would argue that the maturity of the credit cycle, falling risk premiums, and the convergence of global interest rates will serve to further suppress bond market returns.

A dynamic asset allocation approach

Contrary to this popular view, in our opinion a dynamic asset allocation approach to the fixed income asset class will continuously be able to identify a viable opportunity set in the bond markets. The fixed income universe itself can and should provide investors with a set of low volatility alternatives to capture a high growth economic environment. This dynamic approach requires a profound change in the way managers operate. Being wedded to a particular strategy irrespective of the risk/return characteristic will not be valid in this environment. It does not matter whether it is a long or short strategy. The purpose of running any kind of bond strategy and in particular a fund that allows the manager to use the full spectrum of instruments and hedging strategies is to generate alpha. An approach that is driven by asset allocation and then devises individual strategies that fit into this allocation will be the ones that will generate high alphas and Sharpe ratios.

By contrast, the lack of dynamism in the existing approach is characterised by a strict compartmentalisation of sectors in the hedge fund universe. Indeed, conventionally, the fixed income hedge fund universe is broken down into five broad sectors that seem to the investor to be entirely separate. These are: Arbitrage, Diversified, Convertible Bonds, Mortgage Backed Securities and High Yield. This conventional segmentation ignores the fact that managers of the first two strategies in particular have the flexibility to extract value from the opportunity set across all fixed income asset classes, including convertibles, mortgage backed securities and high yield bonds.

A relatively simple illustration of how a more flexible approach could be applied is the continuing convergence of emerging market bond spreads. This trend has largely been ignored by fixed income hedge funds, particularly diversified and arbitrage driven funds. These strategies had the opportunity to participate in the evolving credit story but may have been "stopped out" of this strategy due to a strict adherence to the notion that history will repeat itself (i.e. that emerging markets would revert to a boom/bust behavioural pattern). In fact, long-bias bond managers successfully identified a remarkable transformation in the economic and financial framework in a vast array of emerging markets. This change in economic fundamentals allowed a powerful credit upgrade cycle to develop. This in turn required a different approach to pricing the risk inherent in these markets. A more flexible approach by fixed income hedge fund strategies would have allowed the long bias to remain intact whilst using derivatives to manage risk. Indeed there have been sufficient mini-cycles within a long-term convergence trade to allow a number of long/short strategies to be encompassed within a long bias trade.

Making the most of fixed income

In our opinion there are no structural obstacles that would prevent just such an investment philosophy to be applied to all other credit segments within the fixed income universe. This sort of approach would allow the hedge funds to be in a position to use the diverse fixed income asset class in its entirety.

This would also allow the manager and the strategy to benefit from periods of declining market volatility. This is exactly the key market trend that fixed income managers are faced with right now. It is therefore appropriate to combine market directional trades with market neutral strategies. Such an approach would mean that the manager can run the fund with low correlation bets to efficiently utilise his market skills and risk budget.

This flexible and dynamic approach does not mean that the very ethos of fixed income hedge fund strategies, namely high Sharpe ratios, needs to be abandoned. Indeed in this infrastructure the skill set that encompasses macro, quantitative, credit analysis and technicals will not only serve to boost the Sharpe ratio but also deliver the high alpha that is demanded by our investors.

Hedge Fund Strategy Definitions

Arbitrage Funds: These generally pursue market neutral strategies and seek to profit by exploiting market inefficiencies between securities. The managers use hedging strategies to neutralise interest rate risk. The arbitrage opportunities cover both intra and inter market opportunities.
Diversified Funds: These follow multiple strategies across the global fixed income markets
Convertible Bond Funds: These funds generally hold long only convertible bonds that have hybrid equity/bond characteristics. As the value of a particular stock rises so does the value of the bond. On the downside as stock prices fall the downside is limited as the price of the bond can only decline to where it behaves like a conventional bond.
Mortgage Backed Funds: These invest in mortgage-backed securities including securities such as:government agency, government-sponsored enterprise, collateralized mortgage obligations (CMOs) and stripped mortgage-backed securities (SMBSs). Prepayment risk and interest rate risk is generally hedged.
High Yield Funds: These invest in securities for a combination of income and capital growth through the purchase of fundamentally undervalued securities. There is a significant emphasis on credit analysis.

Sanjay Joshi is Head of Global Bonds and Rabbani Wahhab is Senior Fixed Income Portfolio Manager at London and Capital Asset Management.