On May 2, 2013, the 10-year Treasury yield reached its year-to-date low of 1.63%, before going on rise to 3.04% by year end. This led to a meaningful outflow from investment grade fixed income and conventional income generating strategies in mid to late 2013. Although bonds have surprised on the upside in 2014, with the 10-year Treasury retracing to 2.45% at the time of writing, longer-term investors have heeded the warning signs and continue to seek alternatives to low bond yields and interest rate risk. The potential for hedge funds to help mitigate downside and even benefit from rising rates can make them an attractive complement to traditional allocations for all types of investors, particularly in the current environment.
For many, hedge fund investments are helping to fill the void left by declining fixed income allocations. Since 2002, hedge funds have posted strong performance during periods of rising rates, due in part to their ability to short, hold cash, allocate among different asset classes and move across different sub-strategies. A rising rate environment creates attractive opportunities for specific types of managers, including fundamental equity long/short, credit arbitrage and event-driven managers.
Fertile ground for Long/Short picks
Higher interest rates generally mean that hedge funds receive higher rebates on their short positions. This environment also indirectly exposes the disparity among companies with varying financing structures, margins and business models, leading to higher dispersion among stocks. Consequently, fundamental hedge fund managers find these to be fertile stock-picking conditions, with the ability to generate returns on both the long and short sides of the portfolio by identifying the best and worst stocks.
Benefiting from Credit arbitrage opportunities
These managers also find interesting relative value opportunities during a rising rate environment. For example, a fund could invest in floating rate bank loans and hedge their credit exposure with duration-sensitive fixed rate corporate bonds. This position has a net negative duration and benefits directly as rates rise. Additionally, rising interest rates are associated with rising costs for corporates with floating rate debt financing. Identifying the companies that will struggle to refinance this expensive cost of capital, as a short investment, or those that can refinance this debt as a long investment, also leads to fundamental credit selection decisions.
Risk premiums will rise for merger stories
Merger arbitrage strategies, where investors seek to profit from trading in merger targets, have returns comprised of the risk-free rate and a spread (or risk premium) above this rate. The risk premium, among other things, compensates an investor for risks associated with regulatory approvals, the ability to secure deal financing, shareholder approvals and any uncertainties related to delays in the timing of a deal closing. As interest rates rise, this risk premium typically increases as well, perhaps most obviously because the cost of financing and the ability to secure financing increases. Additionally, the risk-free rate itself is rising, which means the combination of the risk-free rate and the risk premium is higher on an absolute basis in periods of rising rates.
CTA and Global Macro strategies are less well set
Trend following strategies (also known as “CTA” strategies) have historically typically maintained a long position in government bonds, and so offered protection in a risk-off market. However, more recently, low interest rates have made it difficult to trade with a long bond bias. If interest rates continue to rise, CTAs may begin to short government bonds, increasing their correlation to risky assets. This could make them less effective as portfolio diversifiers over the medium term. Similarly, we expect that some global macro funds could experience related issues in the current environment and have historically demonstrated less diversification potential in rising rate environments as well, although they have fared better than CTA strategies.
Timing is difficult
Hedge funds have the potential to protect capital and often benefit from rising rates, which can make them an attractive complement to traditional allocations for a variety of investors. Although the exact timing and future extent of rising interest rates are uncertain and dependent on a number of factors, investors may consider an allocation to hedge funds versus more traditional asset classes sooner rather than later, particularly given the run up in risk assets over periods.
By diversifying across hedge fund strategies and building a conservatively positioned portfolio with a robust short book and modest gross and net exposures, many investors are targeting absolute returns and a low beta to the broader markets during these challenging times.