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Fixed income-focused hedge funds: Return profile across the years

Since the aftermath of the Global Financial Crisis in 2008, the Federal Reserve has kept interest rates at zero to keep borrowing costs low and spur economic growth. This policy had persisted until December 2015 when the Federal Reserve Chair Janet Yellen started the Fed back on a rate-hiking path in a bid to bring interest rates back to normal levels and reduce the size of the Fed’s balance sheet. The target funds rate was increased by 25 basis points from 0.25 to 0.5 percent, marking the first increase in interest rates since the key rate was increased to 5.25 percent on June 29, 2006. Since then, the Fed had maintained steady increases in rates over the years, with the target funds rate reaching a high of 2.25 percent to 2.5 percent in December 2018. In 2019, the Federal Reserve implemented three rate cuts of 25 basis points each in a bid to insulate the US economy from slowing global economic growth. The rate cuts were abruptly accelerated in March 2020 as the onset of the COVID-19 pandemic forced the Federal Reserve to cut benchmark rates to zero and restart quantitative easing to support the ailing global economy. In just a span of three months from end-2019 to March 2020, the yield of the US 10-year Treasury Note had fallen from 1.92% to 0.67%. In addition, the Biden Administration rolled out a US$1.9 trillion economic stimulus package in a bid to give the US economic recovery further fiscal support. The large economic stimulus rolled out thus far caused concerns among some investors over how the central bank will control future inflation, especially since the Fed adopted a new monetary policy framework that allows the inflation rate to exceed its long-term target of 2% before considering any rate hikes. The 5-year inflation expectation moved to its highest level in over a decade, driving the yield of the US 10-year Treasury Note to 1.74% by the end of March 2021. As fixed income instruments are highly sensitive to changes in interest rates, the change in Federal Reserve policy would have a strong impact on the returns that investors would receive from their fixed-income investments.

In this report, we will examine the risk-return profile of the investment-grade debt, high yield debt and diversified debt fixed income hedge funds as represented by the Custom Investment Grade Debt Hedge Fund Index, Custom High Yield Debt Hedge Fund Index and Custom Diversified Debt Hedge Fund Index. The three custom indices are an equal-weighted index comprising of 112, 138, and 194 active hedge funds which invest in investment-grade debt, high yield debt and in both which is being represented by diversified debt, respectively. Hedge funds are classified as indicated on their strategy description, while those fixed income hedge funds that do not belong to the said group such as those who invest in structured credit and trade finance were not included in the index.

Figures 1a-1c show the breakdown of the three custom fixed income hedge fund indices. Investment-grade focused hedge funds investing globally captured the lion’s share of the Investment Grade index with a share of 46%, thanks to the extra diversification benefits of globally exposed portfolios which are more attractive to investors. Unsurprisingly, investment-grade focused hedge funds investing in North America claimed the second-largest share as US treasuries remained the safest debt instrument in the financial market even after the 2008 global financial crisis.

Compared to investment grade fixed income hedge funds, the high yield fixed income hedge fund index is less concentrated. Emerging markets have the largest market share of 25% as it is generally the home of high yield debt instruments – followed by North America, Europe and Global, which have a combined market share of 60% in total. On the other end of the spectrum, diversified debt fixed income hedge funds are more highly condensed compared to their investment grade and high yield peers, with the Global mandate holding more than half of the market share while the North American, Asia Pacific and European diversified debt mandates have a total market share of 47%, leaving the rest of the region with less than 3%.

Figures 1a-1c: Index breakdown by geographic mandate
Index breakdown by geographic mandateIndex breakdown by geographic mandateIndex breakdown by geographic mandate

Figure 2 below compares the performance of the three custom fixed income hedge fund indices, the Custom Investment Grade Debt Hedge Fund Index, Custom High Yield Debt Hedge Fund Index and Custom Diversified Debt Hedge Fund Index against other fixed income benchmarks. The three custom fixed income hedge fund indices displayed a very similar performance since 2008. The Custom High Yield Debt Hedge Fund Index generated an annualised return of 6.03% since end-2007 – followed by the Custom Diversified Debt Hedge Fund Index and Custom Investment Grade Debt Hedge Fund Index with their 5.96% and 5.26% annualised return respectively. On the other hand, the US High Yield Master Index II outperformed the three custom indices as it recorded a return of 7.38% per annum.

Figure 2: Performance of fixed income hedge funds against benchmarks since the end of 2007
Performance of fixed income hedge funds against benchmarks since the end of 2007

Table 1: Performance in numbers – fixed income hedge funds against benchmarks

Custom Investment Grade Debt Fixed Income Hedge Fund Index
Custom High Yield Debt Fixed Income Hedge Fund Index
Custom Diversified Debt Fixed Income Hedge Fund Index
S&P 500
Bank of America Merrill Lynch US High Yield Master II Index
Bank of America Merrill Lynch Global Government Bond Index II

2008

(3.33%)

(17.55%)

(5.19%)

(38.49%)

(26.39%)

8.88%

2009

19.43%

28.13%

25.77%

23.45%

57.51%

0.86%

2010

7.99%

16.21%

10.88%

12.78%

15.19%

3.64%

2011

2.78%

2.25%

0.91%

(0.00%)

4.38%

6.09%

2012

10.49%

12.87%

10.96%

13.41%

15.58%

9.08%

2013

5.76%

7.47%

5.35%

29.60%

7.42%

(4.67%)

2014

3.82%

3.86%

4.65%

11.39%

2.50%

8.37%

2015

0.16%

(0.02%)

1.62%

(0.73%)

(4.64%)

1.22%

2016

6.77%

9.66%

5.42%

9.54%

17.49%

2.96%

2017

4.90%

7.26%

5.88%

19.42%

7.48%

1.16%

2018

(0.41%)

(1.63%)

(0.41%)

(6.24%)

(2.26%)

0.99%

2019

8.06%

9.30%

7.91%

28.88%

14.45%

5.39%

2020

4.05%

6.93%

5.96%

16.26%

6.13%

4.86%

February 2021 YTD return

0.52%

1.13%

1.63%

1.47%

0.73%

(2.92%)

3Y annualised return

3.85%

4.78%

4.74%

11.98%

6.25%

3.02%

3Y annualised volatility

4.58%

6.13%

6.59%

18.51%

9.81%

3.35%

3Y Sharpe ratio (RFR = 2%)

0.40

0.45

0.42

0.54

0.43

0.30

5Y annualised return

4.94%

6.54%

5.67%

14.55%

8.84%

1.78%

5Y annualised volatility

3.68%

4.89%

5.17%

15.07%

8.09%

3.14%

5Y Sharpe ratio (RFR = 2%)

0.80

0.93

0.71

0.83

0.85

-0.07

10Y annualised return

4.45%

5.63%

4.73%

11.12%

6.34%

3.21%

10Y annualised volatility

3.10%

4.34%

4.15%

13.57%

7.23%

4.16%

10Y Sharpe ratio (RFR = 2%)

0.79

0.84

0.66

0.67

0.60

0.29

Table 1 provides the detailed risk return statistics of the five indices shown in the figure above. Key takeaways include:

  1. During periods of strong equity market performance, the Custom High Yield Debt Hedge Fund Index consistently outperformed their investment grade and diversified debt peers as they returned 7.26%, 9.30% and 6.93% in 2017, 2019 and 2020, respectively. On the other hand, during market meltdowns such as the 2008 global financial crisis and the 2018 tech-sell-off, high yield debt fixed income hedge funds underperformed their peers as they recorded 17.55% and 1.63% of losses, respectively.

  2. In 2018, driven by the escalation of the US-China trade war, a more hawkish Federal Reserve and the US-Iran conflict, the market witnessed multiple market sell-offs particularly in October and December, resulting in the S&P 500 recording a loss of 6.24% throughout the year. On the other hand, the three custom fixed income hedge fund indices had outperformed the S&P 500 as they recorded a smaller loss of 0.41%, 1.63% and 0.41% of the investment grade, high yield, and diversified debt fixed income mandates respectively. It is also worth noting that the three custom indices also outperformed the S&P 500 during the 2008 global financial crisis.

  3. In a 10-year period, the investment grade debt and high yield debt hedge funds outperformed the S&P 500, US High Yield Master Index II, and Global Government Bond Index II in generating the best risk-adjusted return as represented in their Sharpe ratio. The Custom Investment Grade Debt Hedge Fund Index and Custom High Yield Debt Hedge Fund Index recorded a higher 10Y Sharpe ratio of 0.79 and 0.84 respectively compared to 0.67, 0.60 and 0.29 of the S&P 500, US High Yield Master Index II and Global Government Bond Index II respectively. The lower annualised volatility of the two custom indices have contributed to their high Sharpe ratio, despite their lower annualised return.

  4. The high yield focused fixed income hedge funds generated an annualised return of 4.78% and 6.54% over the last 3 and 5-year periods respectively, outperforming their investment grade peers who recorded 3.85% and 4.94% return per annum respectively and their diversified debt peers who gained 4.74% and 5.67% on average per year over the same period.

Figure 3: Performance of fixed income hedge funds against other credit-focused benchmarks
Performance of fixed income hedge funds against other credit-focused benchmarks

Source: Eurekahedge

As observed in Figure 3, the Eurekahedge Fixed Income Hedge Fund Index has generated an annualised return of 6.13% since December 2009, outperforming the Eurekahedge ILS Advisers Index which posted an annualised return of 2.60% over the same period but trailed behind their other credit-focused peers. The Eurekahedge Structured Credit Hedge Fund Index was the best performer over the period with an annualised return of 9.92%, followed by the Eurekahedge Distressed Debt Hedge Fund Index with an annualised return of 7.98% and the Eurekahedge Trade Finance Hedge Fund Index with an annualised return of 6.23%.

Table 2: Performance in numbers – fixed income hedge funds against other credit focused benchmarks

Eurekahedge Structured Credit Hedge Fund Index
Eurekahedge Distressed Debt Hedge Fund Index
Eurekahedge ILS Advisers Index
Eurekahedge Trade Finance Hedge Fund Index
Eurekahedge Fixed Income Hedge Fund Index

February 2021 YTD return

2.81%

4.70%

(0.57%)

0.81%

1.39%

2020 return

(3.06%)

6.97%

3.48%

(0.30%)

5.37%

3Y annualised return

3.49%

6.38%

(0.29%)

3.48%

4.64%

3Y annualised standard deviation

13.74%

7.72%

2.88%

1.44%

6.35%

3Y Sharpe ratio

0.11

0.57

-0.79

1.02

0.42

5Y annualised return

6.61%

8.62%

(0.34%)

4.66%

5.94%

5Y annualised standard deviation

10.72%

6.30%

4.58%

1.19%

5.01%

5Y Sharpe ratio

0.43

1.05

-0.51

2.23

0.79

5Y Maximum Drawdown

(22.93%)

(10.53%)

(12.50%)

(1.39%)

(9.35%)


Table 2 provides the detailed risk return statistics of the five indices shown in the figure above. Key takeaways include:

  1. The Eurekahedge Distressed Debt Hedge Fund Index generated a return of 4.70% in the first two months of 2021, outperforming all of their credit-focused peers over the period as they benefitted from the increased optimism of a strong economic recovery in 2021. Looking at 2020 returns, distressed debt hedge fund managers were up 6.97%, outperforming all of their credit-focused peers over the year. Distressed debt hedge fund managers benefitted from the onset of the COVID-19 pandemic which allowed them to purchase the debt of distressed companies at severely depressed prices. The subsequent strong rebound in the global equity market as a result of strong fiscal and monetary policy interventions allowed many distressed companies to turn their fortunes around, boosting the returns of distressed debt hedge fund managers.

  2. Distressed debt hedge funds have generated the highest annualised returns over both 3- and 5-year periods, with annualised returns of 6.38% and 8.62% respectively. However, in terms of risk-adjusted returns, trade finance hedge fund managers have performed the best as their significantly lower 3- and 5-year annualised standard deviations enabled them to generate the highest 3 and 5 year Sharpe ratios of 1.02 and 2.23 respectively.

  3. Apart from the exceptional risk-adjusted returns, trade finance hedge fund managers have also managed to provide incredible downside protection. The Eurekahedge Trade Finance Hedge Fund Index has posted a maximum drawdown of 1.39% over the last five-year period ending February 2021.

Figure 4: Breakdown of fixed income hedge fund population by their 3-year annualised volatility
Breakdown of fixed income hedge fund  population by their 3-year annualised volatility

Figure 4 shows the breakdown of the fixed income hedge fund population by their 3-year annualised volatility. More than half of the combined fund population of the three custom indices had a 3-year annualised volatility of more than 6% and about a quarter of the funds had a 3-year annualised volatility between 3% to 6%. Only about 16% of funds had a 3-year annualised volatility of less than 3%.

Figures 5a-5c: Breakdown of fixed income hedge fund population by their 3-year annualised volatility per category
Breakdown of fixed income hedge fund  population by their 3-year annualised volatility per categoryBreakdown of fixed income hedge fund  population by their 3-year annualised volatility per categoryBreakdown of fixed income hedge fund  population by their 3-year annualised volatility per category

Figures 5a, 5b and 5c show the category breakdown of fixed income hedge funds across the three volatility buckets. From Figure 5a, it is a bit of a surprise that the investment-grade category only has 30% of market share compared to 40% of the diversified debt category, as their performance is known to have lower volatility as seen from their risk-return statistics in Table 1.  Looking at Figure 5b, investment-grade debt captured the lion’s share, with their 45% of market share compared to 36% and 16% market share of diversified and high yield debt. Looking at Figure 5c, funds with a 3-year annualised volatility of more than 6%, diversified and high yield debt have a combined market share of more than 85%, which is expected given their higher exposure to lower-rated debt which is generally more volatile.  On the other hand, investment grade debt only accounts for 14% of market share.

Since the onset of the 2008 global financial crisis, fixed income hedge funds have become increasingly popular among investors due to their ability to produce consistently positive returns and low volatility. The strong flexibility of fixed income hedge funds allow them to adapt to the low-interest rate environment and find alpha by tilting to regions that offer better yields, providing fixed income hedge funds a unique advantage over other alternative fund managers. Having said that, the continued increase in inflation expectations and yields of long-dated bonds are expected to put pressure on the bond market, potentially impacting the performance of fixed income hedge funds in the near future. However, the negative impact of rate hikes on returns is expected to be felt more strongly in the high yield segment, given that investment grade bonds have a history of being able to deliver stable, uncorrelated returns. Nevertheless, based on the past performance of fixed income hedge funds and their strong flexibility to adapt to the rapidly changing environment, fixed income hedge funds are expected to recover as they had during the 2015 to 2016 period when the Fed started gradually hiking interest rates.

The full article inclusive of all charts and tables is available inThe Eurekahedge Report accessible to paying subscribers only.

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