It’s Time for Credit Hedge Funds to Shine

As higher interest rates begin separating leveraged companies into winners and losers, some strategies are poised to profit.


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Higher interest rates are beginning to take their toll on many companies, dividing them into winners and losers and creating a prime window of opportunity for credit hedge funds.

Through the first half of the year, credit funds set a pace for their second-best annual performance in the past five years. PivotalPath’s long-short credit index — which tracks the performance of the strategy as it is used by any of its more than 2,000 hedge fund partners — has returned 3.9 percent year-to-date and 7.2 percent over the previous 12 months.

And the second half of 2023 could be even better, according to Solita Marcelli, chief investment officer at UBS Global Wealth Management Americas.

“We see further value in this strategy for the second half, as it seeks to generate returns from exploiting differences between issuers and using hedges to limit exposure to overall credit market movements,” she said in a July 20 note.

Since the beginning of the year, the financial health of companies that issue high-yield debt has become increasingly bifurcated, which could mean a greater return potential for long-short credit funds. That trend is expected to continue — and will likely accelerate or be prolonged — if interest rates keep rising. (On Wednesday, the Fed raised rates to a 22-year high.)


“The latest 25-basis-point increase in U.S. Federal Reserve interest rates will continue to erode credit quality for B3-rated companies,” said Shirley Singh, a vice president with Moody’s Investors Service, in a July 27 report. “The high cost of capital, combined with difficult lending conditions and weak profit forecasts, has rendered a greater disadvantage for this heavily indebted rating class, and we anticipate that more than half of [all] B3-rated companies will be challenged to meet their interest costs.”

Through April, there were already 236 corporate bankruptcies, more than has occurred in the first four months of any year since 2010, according to S&P Global Market Intelligence.

King Street Capital Management, which manages $23 billion in assets, is also noticing the “haves vs. the have-nots” phenomenon, according to Brian Higgins, the firm’s co-founder, managing partner, and co-portfolio manager. He noted that securities rated A, BBB, or BB with a simple story to tell are performing well, but capital markets are almost completely shut for some relatively high-quality businesses that are lower rated, more complex, or temporarily have negative free cash flow. This is especially the case in the healthcare, technology, media, telecom, and cyclical sectors.

“These dislocations should not come as a surprise — when interest rates move rapidly from 0 percent to 5 percent, there will always be a lot to do in the credit universe. However, the divergence cannot go on forever — eventually we believe there will be either a soft-landing that reopens capital markets for stronger businesses that were lumped together with weaker ones, or else we will have a recession that brings today’s high-flyers back to earth,” Higgins said. “Until we know which outcome is happening, it’s prudent to position in relatively safe, high-yielding, short-duration credits.”

UBS said that it expects convertible bond arbitrage strategies — which have historically generated average annualized returns comparable to equities but with much less volatility — to perform well. (PivotalPath’s convertible bond arbitrage index is up 4.5 percent this year and has returned an annualized 9.9 percent over the past three years.) But UBS cautioned that rising default rates could make selecting companies more important, causing investors to choose managers that have conservative approaches and good hedging capabilities.

If more companies struggle to make loan payments in the coming months, distressed debt managers might also generate better returns, partly because lower-rated credit markets have grown in size during recent years, providing additional opportunities, UBS said.

The impact of higher interest rates has already hit floating-rate securities, but a second wave of pain is coming for some companies that need to refinance. Only 5 percent of high-yield bonds have reset higher over the past 12 months, but nearly 30 percent of the market will reset by the end of 2025. Talk of a recession not happening until 2024 or later is also pushing some companies to refinance now while they think their performance might be better, Higgins said.

“This is especially true in the U.S. commercial real estate market, where private transaction volume is already down 70 percent year-over-year. In our view, many sellers will remain on the sidelines until they are forced to transact due to interest rate cap expiration, covenant breaches, or fully extended loan maturities,” Higgins said. “Despite record loan maturities and sharp declines in unlevered asset values, the bias among lenders is usually to extend, especially for cash-flowing properties and creditworthy sponsors.”

Dushyant Mehra, co-CIO of Hildene Capital Management, a credit hedge fund that manages $14.3 billion in assets, said that there are opportunities in certain collateralized loan obligations and residential mortgage-backed securities which are priced for a worst-case scenario. If the expected defaults don’t happen, the credit convexity will lead to good returns. “Current markets afford the ability to source these bonds to extremely draconian scenarios, with upside to loan prices rising when credit stress calms,” Mehra said.

According to Preqin, investors have yanked billions of dollars out of credit hedge fund strategies in recent years, with outflows of $16.8 billion 2020, $8.4 billion in 2021, and $18.6 billion in 2022. But through the first quarter of 2023, credit hedge fund strategies had inflows of $3 billion, bringing their total assets under management to $288 billion.

“It makes sense to want to be in credit. I think the hedge fund space — the long-short credit and distressed — makes a lot of sense,” said Jonathan Caplis, CEO of PivotalPath. “But I don’t think it’s just a simple story, that now is the time where everybody has to get in. I think, like anything, that diversification, and maybe overweighting a little bit to those types of credit strategies right now, would be a good thing to do.”