Changing attitudes to fixed income strategy influencing funds universe

Managers who pursue a long/short fixed income strategy aim to make profits from changes in the absolute value of fixed income instruments. They select undervalued fixed income instruments and go long in them hoping they will increase in value.

They then sell short fixed income instruments which they think are overvalued and will decrease in value. If the value movements are correct, they make profits on both sides of the trade.

However, there are many different ways of running this kind of long/short fund. Colin Fogwill, fund manager of Elite Integrity European Income Fund, says fixed income long/short is under pressure from inflation and interest rates. He says the strategy depends on how long it takes inflation to go down and what stages it goes through.

Fogwill says people have been spooked with what they have seen over the last 10-11 months. "I read that one of the large banks with a wealth management arm said most traders were purchasers meaning there are more buyers than sellers but I think people will wait for an upturn in the equity markets," he says.

It will be six months before the equity markets recover, according to Fogwill. He thinks the equity markets will outperform fixed income markets. "I feel that over the next six months there will be more direction on the markets from an interest rate point of view, but I am unsure we will know all we need to know on the inflation front by then and that is why fixed interest strategies may prove difficult. More so than equities which can handle inflation better and therefore could recover far quicker than fixed interest," Fogwill concludes.

MD Sass ReEnterprise Partners, a subsidiary of MD Sass, is a major player in the fixed income long/short area. Byron Haney, a portfolio manager in the fund, says doing trades "inter-capital structure" (within the same company's capital structure) is one of the fund's 'favourite' types of deals.

"The classic way we do it," says Haney, is to go long a company's secured bank debt and then short the same company's unsecured bonds. "We do it when we know a company's credit is deteriorating," he says.

Money can be made through both trades. This is because as a company's credit deteriorates, the price of its bonds will drop. However, the value of bank debt will go up because the bank is a secured lender of the company and the first in line to get paid if a company goes into bankruptcy.

MD Sass ReEnterprise also runs First Commercial Credit Corp, a wholly owned subsidiary of the fund. This provides credit protection to vendors that are dealing with distressed companies. Haney says it is something like factoring in the retail industry.

While the fund takes the collection risk of the vendor's receivables, it protects itself by either shorting the company's bonds or buying protection through credit default swaps.

"It virtually assures us of making a profit," says Haney. "The vendor pays us and then we offload the risk with a more sophisticated financial instrument."

With credit default swaps, the fund is buying protection because it pays a counterparty for the right to sell them the bond for 100% of the price if there is a default event in the future.

"As a company's credit deteriorates it gets more expensive," explains Haney. "You create a short position by buying the credit default swap protection."

Then one of two things happens, he says. If the company goes into default, the investor gets 100 cents on the dollar for the bonds. More often the credit quality of the company deteriorates and the credit default swap becomes more expensive and it can be sold back to the dealer.

Haney says the fund now has a trade on Southwest Airlines. The fund "bought protection a few months ago and now that oil prices have gone up the price of protection goes up so we could sell it to someone else at a profit," he says. The fund is using the position to hedge some long positions it has in airline stocks.

The fund also is using "intra-capital structure arbitrage" on MBIA (a US monoline insurer primarily of municipal bonds and on asset-backed securities and mortgage-backed securities) for which it has a short position at the holding company level and some long exposure in MBIA at the insurance company level.

"First you have to get value to the operating company before you can get much value to the holding company level. You can be long safe instruments and short the risky bonds," explains Haney.

Schultze Asset Management, which invests in all types of distressed securities, including short bonds. When the company shorts debt, it shorts subordinated bonds that have "equity like characteristics," says George Schultze, founder and portfolio manager.

The company does not invest in credit derivatives but does invest in unsecured bonds. The theory is the same as shorting equities, according to Schultze. The equity holders in a bankruptcy either get completely wiped out or their shares are substantially diluted.

Schultze has also shorted publicly traded bonds of privately owned companies. "We short the debt because the stock doesn't trade. From time to time we find a bond with an equity-like return, and we short it," Schultze says.

Integrity Fund Managers's Fogwill says pension funds are selling equities but are not yet big fixed income investors. "They are not bulk buying fixed interest as the yields available are quite clearly producing a fair amount of risk. There seems to have been interest from pension funds into property in the last few months which is premature given the economic problems. You have to wait until there is a solid expectation of interest rates dropping," he adds.

Thames River Hillside Apex Fund is a global credit long/short fund with assets under management of approximately $1.2 billion and a 10-year track record. Over the past five years, the fund's US dollar share class has produced annualised returns of 11.7% with a standard deviation of 3.64%, maximum drawdown of 2.46% and Sharpe ratio of 2.14%. The fund combines top down macro investing focused on emerging market sovereign debt with developed and currency markets hedging overlays.

The fund also has a diversified, primarily long only value driven bottom up strategy focused on emerging market and developed market sub-investment grade corporate bonds.

Ed Morse, sales director at Thames River Capital, believes this strategy will lead to more opportunities. "The recent market turmoil is leading to a generalised repricing of risk which the management team believes will lead to opportunities to lock in higher returns from individual credits going forward. This may also lead to increased opportunities over the course of the coming months to invest in distressed corporates at attractive prices," says Morse.

Philip Pearson, head of alternative investments at Morley Fund Management, which runs the Morley Fixed Income G7 Fund, says a well managed fixed income arbitrage strategy provides an excellent source of consistent returns.

It is a source of low volatility returns, according to Pearson. "Our sterling returns over the last 12 months have been 12.5% which is not a very high headline return but those have been achieved with volatility of 2.4% which is very low. One of the secrets to the returns is being very disciplined in terms of diversification and in the timing and sizing of the trades we make."

Pearson says the strategy is influenced by four different drivers. "It depends on what is happening in interest rates, foreign exchange markets, inflation and also supply and demand. These expectations are at the heart of the strategy.

"In general terms, the strategy tends to perform better when yield curves are steeper, when inflation is low and predictable and when a lot is happening on the supply and demand side," says Pearson.

Two years ago, flat yield curves and low volatility made it a tough time for the strategy. "We had to look carefully at our approach and invest heavily in the techniques we use for timing trades," Pearson says.

"In the last year, up until fairly recently, these criteria have been met and conditions have been good for our strategy. Right now, it is hard because there are big question marks over the fixed income market in terms of what will be the prevailing driver and whether it will be lower economic growth or recession or inflation or both," adds Pearson.

Whatever the market believes is the right combination will determine how managers will respond and act, believes Pearson. He admits everyone finds it hard to predict what will happen but knows that that is why you have talented managers who make the difficult calls.

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