Upsides and downsides of a bond-based opportunity

Bonds cannot rally for ever

The past 20 years of strong monetary control by developed governments, global disinflation and easier capital flows have resulted in an exceptional bull market in bonds. Informed investors know that this bull market cannot continue at the recent pace without a move to strongly negative nominal interest rates, which is most unlikely on a global basis.

Evidence of this bull market has been that yields as low as 0.36 per cent were seen for 10 year Japanese government bonds as recently as June this year, compared with equivalent yields of over 5 per cent only 10 years ago. The days of high returns from long-only bond investing are numbered; fixed income hedge funds should thrive nonetheless.

Asymmetrical bond price

Bonds are bounded in a way that equities are not because they redeem at fixed price, or, in the event of default, subside to some lower value.

Looking at both asset classes on first principles, it is clear that on the “long equity” side there is a downside limit of 100 per cent – the investor loses all his/her money if the equity becomes worthless – but no

theoretical upside limit as there is no maximum beyond which a stock price cannot rise. The converse is true for the ‘short’ side – upside is constrained but downside conceptually unconstrained.

A long/short pair trade in a bond has fundamentally different characteristics. As with an equity, a long bond position has a maximum downside of 100 per cent – total default will wipe out the value of the investment – but limited upside for bonds.

Unlike equities, whatever it does in the interim, every bond will eventually track towards its redemption price or, in the case of a default, a lesser value. The short side is the mirror image of this – the downside is limited to the amount by which the price of the bond can rise and its upside is 100 per cent – in the event of total default. This makes the short bond position much less risky than the short equity position.

Global bond homogeneity

Almost all bonds have a coupon, fixed maturity amount and set maturity date. Bond markets have operated on a truly global basis for much longer than equity markets – since the imposition of withholding taxes in the US in the 1960s. And the similar ways bonds are structured, priced and traded makes global implementation of hedge fund trading strategies inherently easier than in equity markets.

The world’s bond markets are the largest and most liquid markets in the world. Bid/offer spreads are tight and no commission is levied on trades. According to the International Securities Management Association (ISMA), at the end of June 2003 bonds in issue exceeded $6900bn (e5900bn), with over 60,000 different bond issues.

Tempered management

Painful though it is to recall, the most well-known example of a (predominantly) fixed income hedge fund is undoubtedly Long Term Capital Management (LTCM).

One effect of LTCM’s demise was to frighten many market participants and potential investors, and this has no doubt reduced both the supply of and demand for fixed income hedge funds.

However, it has become very clear since LTCM’s bail-out that its failings were not the result of its operating in bond markets per se, but much more the consequence of very high gearing combined with less-than-perfect risk controls. Thus, since 1998, management styles have generally deployed lighter gearing and more thorough risk controls than before.

Excellent performance

Fixed income hedge funds have performed well. The average sector return for the equity long/short universe for 2003 was 2.8 per cent and 2.3 per cent for the last 12 months, compared to 5.2 per cent and 16 per cent respectively over the same periods for the fixed income sector (source: Eurohedge, $ classes).

We believe there will be continued growth in fixed income hedge funds. After its long-running secular bull run, the global bond markets provide a liquid market in which prudent hedge fund managers can trade instruments in a risk-controlled manner to generate risk-adjusted returns which will appeal both to the numerous long-only bond managers and their equity-focused hedge fund brethren.

Tim Haywood, head of fixed income, alternative investments, Julius Baer Investments Ltd.

‘Bonds are bounded in

a way that equities are

not because they redeem

at fixed price, or, in the

event of default, subside

to some lower value’

Tim Haywood, Julius Baer Investments Ltd