By Neil O’Hara
Credit-oriented hedge funds have been on a roll for two years, but it won’t be long before the Federal Reserve tries to end the party. The central bank is getting ready to back away from the easy monetary policy it has pursued ever since the financial crisis erupted in late 2008, ending its second round of quantitative easing in June. It is a question of when, not whether, the Fed will begin to nudge interest rates higher—and put credit hedge fund managers to the test.
The credit-focused hedge funds tracked by AR returned 33.48% on average in 2009, a banner year for credit strategies, and gained another 14.55% in 2010. Now, however, managers face a tougher environment—but they still have a few tricks up their sleeves to keep making money.
Fixed-income securities prices have an inverse relationship to interest rates, so managers need to hedge against losses when interest rates rise. The most popular strategy is to shorten the duration of their portfolios all the way down to zero. Duration is simply the average life of cash flows—principal and interest payments—and is a measure of interest rate sensitivity.
An uptick in interest rates isn’t an automatic negative for investors exposed to credit risk rather than duration. The Fed tightens monetary policy only when the economy is growing, which means corporate cash flow is strong and the credit quality of high-yield issuers is improving. The spread between high-yield bonds and Treasuries tends to narrow during these conditions, and may even more than offset any increase in rates, at least for a while. “Typically, the early part of a tightening cycle continues to be a positive environment for credit spreads,” says Jon Duensing, head of corporate credit at Durham, N.C.–based Smith Breeden Associates, a fixed-income-focused investment firm that manages $6.5 billion. “You still see preference for risk assets over risk-free assets.”
Long-only managers often protect their portfolios against rising rates by shortening duration relative to their benchmarks. Hedge fund managers apply the same technique but take it a step further. Duensing has cut duration close to zero in Smith Breeden’s absolute return strategy portfolios, which focus on long/short relative value plays and special situations in the fixed-income markets.
The long side is typically high-yield bonds, which have an average duration of 4.5 years, so Smith Breeden hedges the interest-rate risk by selling short five-year Treasuries. “Regarding current corporate credit exposure, we prefer to be long spread risk and short interest rate or duration risk,” says Duensing. “It is about isolating the spread premium—the compensation for default risk and volatility, or uncertainty—over risk-free rates.”
To David Edington, founder and president of San Juan Capistrano, Calif., firm Rimrock Capital Management, the prospect of higher interest rates is not a major concern. While working at PIMCO early in his career, he became convinced that fixed-income securities with short maturities—nine months to three years—generate the lion’s share of the return available on longer-dated instruments with a fraction of the price volatility. Rimrock’s flagship vehicle, the Rimrock High Income PLUS Fund, sets target duration at one year, although the manager has flexibility to shift up to two years either side of that benchmark. Right now, Edington has shaved average duration to about six months. “If rates went up 300 basis points, that would cost us 1.5%,” he says. “We don’t have a tremendous amount of risk on interest rates.”
In contrast to long-only funds, near-zero duration does not imply near-zero returns for a hedge fund. Rimrock High Income PLUS posted a 19.9% gain for 2010 on top of a 32.5% gain in 2009. The firm manages $1.4 billion.
Edington attributes the recent gains to the rebound from the financial crisis. As corporate default rates fell and house prices showed signs of stabilizing—or at least declining more slowly—investors were able to substitute rigorous analyses of cash flows for mere speculation about potential credit losses. As soon as people became convinced that cash flow was predictable for a sector of the fixed-income market, prices shot up and began to trade at a spread to Treasury securities of equivalent duration. Rimrock capitalized on this last year, but the phenomenon drove performance in other fixed-income sectors too.
The game is not entirely played out. “A year ago we were shooting fish in the barrel and pulling them out with our hands,” says Edington. “Now we are back in the boat, looking under logs and casting into the weeds, but it’s still pretty darn good fishing.”
Rimrock casts its net wide and isn’t afraid to trawl for pearls amid the toxic waste of the credit crisis. It recently bought a bond that was ultimately backed by a collateralized debt obligation of subprime mortgage-backed securities, for example.
The senior tranche of the underlying CDO had been resecuritized once, and the senior tranches of the repackaged vehicle had in turn been resecuritized a second time. Rimrock bought a mezzanine bond senior to 36% of the newest structure in a tranche representing more than 15% of the total capital, a far more attractive risk-reward proposition than the mezzanine tranche in a typical vintage CDO. Edington usually sticks to the senior tranches in structured debt, but in this case he made an exception. To get the same yield from the AAA-rated senior tranche would have required more than three times leverage. In a worst-case stress scenario—back to post-Lehman market conditions—Rimrock reckoned a levered position in the AAA bonds would be wiped out, while the unlevered mezzanine investment would still recover 70% of principal.
Such careful analysis is a hallmark of successful credit hedge fund managers. Stephen Siderow, co-founder and president of $4.4 billion BlueMountain Capital Management, a relative value credit-oriented hedge fund manager, sees the new market for enhanced capital notes and contingent convertible bonds issued by European banks as an attractive play in the current environment. As interest rates move up, the yield curve will flatten and squeeze bank profit margins, although the severity will vary with each bank’s business mix. If profit margins get squeezed enough, the notes will convert—which can create interesting opportunities, says Siderow. BlueMountain hedges its exposure to ECNs and CoCos with other classes of the same bank’s capital.
BlueMountain generates its returns from a combination of long/short corporate credit plays based on fundamental research; capital structure arbitrage in structured debt, including collateralized loan obligations and mortgage-backed and asset-backed securities; and index arbitrage between the credit default swap indices and the underlying single-name components. Last year, about 45% of the returns came from the corporate bond side, 45% from structured debt—mostly in equity tranches of CLOs—and just 10% from index arbitrage, reflecting the low market volatility. The flagship BlueMountain Credit Alternatives fund was up 12.5% in 2010 and had gained another 3.9% through the end of March.
BlueMountain keeps duration close to zero at all times, exchanging fixed-rate exposure for LIBOR-related cash flows through interest-rate swaps. The whole portfolio is floating rate, which means higher short-term rates will boost returns. And the cash BlueMountain puts up as margin at its swap counterparties and the excess cash it holds as a cushion on its own balance sheet will earn more if short-term rates rise.
“It is a second-order inflation hedge,” says Siderow. “It is not just zero duration. If rates go up, we will make more money, not through trading but because of what we earn on cash.”
Some credit hedge funds take a more flexible approach to duration. New York–based Ore Hill Partners, which manages $800 million in hedge funds and another $1.1 billion in structured debt, does make directional bets, as it did in early 2009 and in the wake of the Enron debacle years ago. At other times, however, the fund turns to event-driven and arbitrage opportunities that have little correlation to interest rates. “We feel the beta trade is over,” says Ben Nickoll, co-founder and chief investment officer of Ore Hill. “We are looking for corporate catalysts—reorganizations or an earnings event—to drive price action.”
Nickoll cut his teeth in the high-yield department of Lehman Brothers, and his senior colleagues at Ore Hill all have similar backgrounds. The manager, soon to be wholly owned by Man Group (which bought a 50% stake in 2008), straddles the divide between event-driven credit and distressed securities. But at heart Ore Hill is a fundamental, credit-focused investor. The major directional plays tend to unfold over extended periods and begin at cyclical extremes—like today’s ultralow short-term interest rates. That’s why Ore Hill has supplemented its arbitrage book with swaptions on interest rates, a form of insurance that will pay off when rates go up.
A typical long position pays a double-digit coupon but is senior enough in the capital structure to be protected in all but the most extreme circumstances. It could be a mortgage bond in a short duration tranche that has at least three times as much junior paper beneath it in the capital structure, or a senior corporate bond protected by a slug of junior debt as well as equity. High-yield bonds like these have a significant equity component in the valuation, which means they aren’t all that sensitive to interest rates. If the company prospers, Ore Hill makes money as the credit spread over Treasuries narrows, but if the company runs into trouble and has to restructure its debt, the senior bonds usually come out whole anyway.
Ore Hill sometimes dabbles in the investment-grade bond market too. Nickoll sees potential short opportunities today among corporate bonds that are trading at low spreads over Treasuries where the issuer may releverage the balance sheet through a merger transaction. He’s also eyeing the anomalous spread that has emerged in recent years between yields on bonds issued by investment-grade financial companies versus industrials. “Financial companies are so heavily scrutinized now, they will continue to cut risk and leverage for the foreseeable future. They have probably never been safer,” he says. “We are trying to figure out the near-term catalyst that will narrow that spread.”
The prospect of higher interest rates strikes fear in the hearts of conventional fixed-income investors, but to credit hedge fund managers it’s one more shoal to navigate. They just have to work harder for their money now.
