Pine River Capital Management’s Steve Kuhn |
Hedge funds focused on credit and fixed income have been on a tear for the past four years, especially those focused on the mortgage markets, and many of these funds are off to strong starts this year as well. But is their hot streak set to cool off soon? The question is top of mind for yield-hungry investors, who poured into these strategies in search of higher returns following the financial crisis of 2008. As the economy and the financial markets strengthened and central banks throughout the world continued to ease their monetary policies and buy up mortgage-backed instruments and other securities, prices on many of these riskier securities surged, further boosting returns and tightening spreads.
Investors in mortgages, especially those not backed by agencies such as Fannie Mae and Freddie Mac, also grew more optimistic as home prices began to rise and mortgage delinquencies fell. The Case-Shiller Home Price Composite Index for 20 cities rose 1 percent in January — the most recent month for which this data is available — making it the 12th straight monthly increase. What’s more, in the past year home prices have climbed 8.1 percent nationwide.
Investors in credit-focused hedge funds were rewarded handsomely for taking those risks: The large variety of subgroups tracked by industry tracker eVestment, which includes asset-backed securities (ABS), mortgage-backed securities (MBS) and residential mortgage-backed securities (RMBS), on average gained between 16 percent and 26 percent last year among the various strategies and between 18 percent and 54 percent in 2009 and 2010. In 2011, these funds on average posted high single-digit returns in a year that the average hedge fund lost money.
However, several market participants warn that the big gains in those markets are poised to slow down this year after the explosive four-year run, and they are becoming more cautious on the group, especially as the economy shows signs of slowing down.
“Returns over the last four years were outsize,” stresses one manager who posted very strong results but declined to be named. “Last year was an outlier year.”
Indeed, several large hedge funds posted strong gains last year from their structured-credit portfolios, including David Tepper’s Appaloosa Management. Tepper’s performance landed him at the top of this year’s Rich List ranking of top-earning hedge fund managers. Daniel Loeb of Third Point also made the Rich List, thanks in part to big gains in structured credit.
Among the top-performing credit funds in 2012 were several managed by Pine River Capital Management, a Minnetonka, Minnesota–based fixed-income hedge fund firm with $7.8 billion in assets. The firm’s Pine River Fixed Income Fund rose 35 percent, the Pine River Liquid Mortgage Fund gained 29 percent and the Pine River Fund climbed nearly 22 percent. Another top performer was the Metacapital Mortgage Opportunities Fund, managed by Deepak Narula, a one-time head of two mortgage-backed securities trading desks at Lehman Brothers who currently manages $1.5 billion from his New York office. It surged more than 41 percent last year. Meanwhile, the Halcyon Offshore Asset-Backed Value Fund has posted double-digit returns in three of the past four years, including 16.14 percent last year. It is managed by New York City-based Halcyon Asset Backed Advisors; its portfolio managers are James Coppola, Joseph Godley and Joseph Wolnick. Among smaller funds, last year the Brookfield Global REITS Long Short fund rose 40 percent in 2012, while the $260 million BTG Pactual Distressed Mortgage Fund surged 45 percent. It is managed by São Paulo-based BTG Pactual Group.
So far the gains have kept up this year: According to eVestment, securitized credit funds, which invest in securities backed by credit cards or other receivables, were up 4.06 percent on average in the first quarter; relative value credit rose 2.51 percent; mortgage strategies climbed 3.29 percent; and ABS-focused funds gained 6.01 percent. Subprime mortgages have performed especially well in this environment. In addition, many of the mortgage hedge funds use leverage, which further gooses returns. But market observers warn that these funds may not have much further to run.
“Despite the strong start for these funds to 2013, prices of securities in certain segments of these markets are no longer broadly moving higher,” eVestment points out in a recent report.
For example, Metacapital’s two funds were up between 2.5 percent and 4 percent in the first quarter, according to an investor in the funds. Pine River’s funds have enjoyed mixed success this year. For example, its Fixed Income Fund is up 5.9 percent and its Pine River Fund, the multistrategy fund, is up 6.37 percent. However, its Liquid Mortgage Fund is down slightly, by 0.36 percent.
Many funds are being hurt by the tightening of interest rate spreads. “High-yield and leveraged loans are very thin,” wrote Gideon King, chief investment officer of the Loeb Arbitrage Fund Class B, which climbed just 2.41 percent in the first quarter, in a letter to investors dated April 15. “Perhaps 5.7 percent spreads to treasury should move us all to rename the market the ‘low-yield market.’ At some level, high-yield bonds present asymmetric risk-reward ratios, providing little upside and equity-oriented downside.” The fund is managed by New York-based Loeb Capital Management.
Noah Estrin, portfolio manager for London-based investment adviser Prologue Capital, points out in an April 10 letter that since September, spreads on agency MBS have tightened significantly. As a result, many investors, especially indexed investors, have been “fairly significant” net sellers of MBS in order to bring down their overweight position.
Meanwhile, investors have pulled money out of MBS-focused funds for three of the past four months, suggesting that investors are starting to distinguish among the credit groups. Hedge fund adviser Jonathan Kanterman says that while ABS funds have enjoyed a three-year run of outperformance, finding undervalued ABS assets is now becoming harder, making it less attractive to put on arbitrage trades among ABS as the strategy has become a crowded play.
“Investors are taking some of their allocations off the table,” says Kanterman. “New money is not flowing in like it used to.”