ALTERNATIVES - Betting the Spread

Fixed-income hedge funds plunge into unconventional areas.

Pity the hedge fund managers who focus on fixed-income securities. With the yield curve flattened and credit spreads hovering at record lows, arbitrage profits are increasingly tough to come by, even in such traditional hunting grounds as the junk bond and emerging-markets debt sectors. To maintain returns, managers are not only taking on more risk in these asset classes, they are also venturing into “fringe areas of the credit markets,” says David Tsujimoto, director of alternative investments at Tacoma, Washingtonbased Russell Investment Group, which manages about $20 billion in hedge fund and private equity assets.

A case in point, says Tsujimoto, is municipal bonds, where hedge funds have begun going toe-to-toe with the tax-sensitive individual investors who make up most of the market. Since these conservative buyers seek income and tend to hold the bonds rather than trade them, munis are considerably less liquid than Treasuries or corporate bonds. Still, this buy-and-hold investor base provides a singular advantage: The muni yield curve never inverts, enabling arbitrageurs to pursue classic strategies -- going long a ten-year bond, say, while shorting a two-year bond -- that no longer deliver profits in the heavily traded Treasury market.

Some managers prefer more exotic strategies. Gery Sampéré, a co-founder and portfolio manager of New Yorkbased BlueMountain Capital Management, a hedge fund with $3.1 billion in assets, is trading credit derivatives against bonds, playing spreads among different asset classes and exploiting inefficiencies across the corporate capital structure -- for example, by trading senior secured debt against unsecured debt.

Sampéré is also adding equities to the mix. Last year, his firm launched a fund that trades credit against equity, equity derivatives and credit derivatives. “We look at relative values,” says the London-based Sampéré, who launched BlueMountain in 2002.

Spreads won’t stay compressed forever, of course, and BlueMountain is positioning itself to profit when the cycle turns. Sampéré favors buying senior debt and selling short a smaller amount of the junior debt of the same company in a ratio that earns income even after the cost of borrowing has been accounted for, generating what is known as a positive carry. If credit spreads widen, the junior debt will likely fall further than the senior debt, potentially delivering a capital gain on the trade. “You have to understand the risk and have a view on the potential recovery rate differential between those different asset classes in the capital structure if something goes wrong,” explains Sampéré.

Hedge funds are also trading bank loans to sub-investment-grade borrowers; issuance last year, at $480 billion, was up 63 percent from 2005. Sebastien Fiaux, deputy head of event-driven strategies at Credit Suisse’s New York office, says hedge funds can build income-producing positions by focusing on loans that pay, on average, 250 basis points over LIBOR; if investors leverage three to one, he says, they can earn nearly 1,000 basis points above their financing cost.

There are risks. Even though bank loans take priority over most bonds and have historically high recovery rates in the event of a default, lenders have begun offering less stringent covenants. Investors may be underestimating the potential for capital losses. “If there are more loans as a proportion of the capital structure, the historical measures of recovery might not be accurate,” says Fiaux.

Structured debt issuance has also exploded, creating opportunities to capture valuation anomalies. Russell’s Tsujimoto says hedge funds are trading unrated or sub-investment-grade tranches of collateralized debt obligations and collateralized loan obligations, where banks and insurance companies are loath to tread. “Supply is great, and there is a lot of inefficiency in the pricing,” he says.

For some strategies, tight credit spreads are a mixed blessing. Convertible arbitrage managers derive less return from coupons but have more trading opportunities: Issuance ticks up because convertible debt becomes relatively cheap financing. Merger arbitrage managers are in a similar position. Although they benefit from increased deal activity prompted by easy financing, the flood of cash transactions and leveraged buyouts render their portfolios more exposed to credit risk.

It seems you can’t keep a creative hedge fund manager down. But creativity requires a trade-off. Only when credit spreads widen dramatically will the market reveal which managers truly understood the risks.