Fixed Income funds

Fixed Income Funds

Fixed income funds come in many sub forms and many of them are parallel to equity strategies. For example long/short fixed income mainly engaged in relative value spreads. A typical trade is being long a high yielding corporate bond and selling a risk free treasury. Here the trader believes that the credit outlook of the corporate will improve but does not want to take interest rate risk and therefore sell treasuries to eliminate that component. Hedge funds also very often trade the slope of the yield curve. Here the trader either believes that the yield curve will become steeper and to profit he will buy a short term bond e.g. a 6 month treasury note and short the 10 year treasury bond, or perhaps he can forecast the yield curve will flatten or even invert, where he will take the reverse position described. A very famous hedge fund trade that was taken on by Long Term Capital Management was to buy an Off the run 30 year treasury and sell a current on the run treasury and profit by the spread narrowing (further details of the above fixed income strategies are outlined in the fixed income article on this website). In terms of the current situation spread traders who were long the short term end of the curve and sold the long end lost out with the fed raising rates over the past couple of years.

Fixed income funds who concentrate on asset backed securities like mortgage bonds have profited the most out of the various different strategies. However they are faced with greater risks especially with house prices dropping and mortgage buyers defaulting. Other exotic fixed income trades include trading corporate bonds versus credit default swaps and put options. Here a hedge fund can use their quantitative black box system to spot discrepancies in fair value of the different components of a structured fixed income product. A familiar one which we described above is convertible bond arbitrage. Hedge funds make up for around 60-70% of convertible bond activity and over a third of the credit default swap market.

One area of fixed income which is growing in hedge funds is the leveraged loan sector. This year is the first year where hedge funds account the most in terms of activity. One reason is the rise of collateralized loan obligations (CLO) vehicles run by financial institutions which split loans into different tranches offering different yields.

Fixed income hedge funds have returned on average 7.8%. This compares to the 5.25% yield returned on fed fund rates in October 2006. Braddock Financial was the fund with the highest 3 year return at 22.2%. Fixed income funds generally have lower returns but also have less risk and volatility.