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Rush to Hedge Funds Seen Courting Lame Returns: Credit Markets

Date: Tuesday, October 29, 2013
Author: Lisa Abramowicz, Bloomberg

Debt investors are funneling 17 times more cash into hedge funds than into junk-bond funds that returned more in each year since the crisis, heralding a shift from chasing yields to preserving cash as interest rates rise.

Hedge funds that seek to profit without making large bets on the direction of debt prices received $20.6 billion in the first nine months of 2013, compared with a net $1.2 billion put into junk-bond mutual funds, according to data from Hedge Fund Research Inc. and EPFR Global. The flows are a reversal from 2012, when $72.1 billion deposited into the mutual funds was almost twice the $41.4 billion allocated to hedge funds.

Pension plans, endowments and other institutional investors facing the sparsest bond gains since 2008 are leading the charge into hedge funds that returned about half as much as a broad index of high-yield bonds in the four years after the seizure in credit markets. Investors who’ve been led into riskier assets as the Federal Reserve pushed benchmark yields to record lows are now seeking insulation as rising rates erode returns with economists predicting the central bank will slow its stimulus next year.

“They’re getting nervous about the withdrawal of central bank liquidity,” Monica Issar, the head of J.P. Morgan Asset Management’s endowments and mid-sized pensions group, said in a telephone interview. “In the credit space, it’s not as easy anymore. You need skilled managers, people who can trade in significant market turmoil.”

BlueCrest Capital

BlueCrest Capital Management LLP, the London-based firm led by former JPMorgan Chase & Co. trader Michael Platt, has increased its assets by $7.2 billion since the end of 2011 to $35 billion, according to a person with knowledge of the matter. Pine River Capital Management LP, founded in 2002 to pursue opportunities in global relative-value trading, boosted its assets by $8.2 billion since January 2012 to about $13.6 billion.

Relative-value hedge funds, which make both bullish and bearish wagers to profit from price discrepancies between securities, have posted average annualized gains of 12 percent in the four years since 2008. That’s about half the average 21.6 percent return each year for the Bank of America Merrill Lynch U.S. High Yield Index.

Losing Steam

Almost five years after the Fed started pumping more than $3.27 trillion into the financial system to spur economic growth, investors are struggling to find assets that will hold their value as the central bank considers slowing its stimulus.

After returning an average 11.3 percent annually the previous four years, corporate bonds globally are on pace to gain 1.6 percent this year, according to the Bank of America Merrill Lynch Global Corporate & High Yield Index. That would be the worst annual return since the market lost 7.5 percent in 2008 amid the worst financial crisis since the Great Depression.

The debt plunged 2.2 percent in the three months ended June 30, the worst quarterly loss since the period ended September 2008, as benchmark borrowing costs rose after Fed Chairman Ben S. Bernanke outlined a road map for the central bank to reduce $85 billion of monthly bond purchases if the labor market showed sustainable improvement.

Taper Losses

“People always viewed bonds and long-only bond funds as a stable anchor to their portfolio,” said Chris Paolino, senior vice president and head of hedge-fund investments at Hartford Investment Management Co. “What we got this summer was we showed people interest rates could go higher along with stock prices going down. It made people question the efficacy of the protection of their bonds.”

The hedge funds are being looked to as a buffer even after the loosely regulated investment vehicles were blamed for exacerbating the crisis five years ago. By using derivatives and borrowed money to boost leverage in an effort to amplify returns, the funds instead magnified losses after markets seized up when Lehman Brothers Holdings Inc. filed for bankruptcy protection, Fed Bank of New York researchers Jaewon Choi and Or Shachar wrote in a report this month.

Dollar-denominated junk bonds lost 31 percent in the three months after Lehman’s September 2008 collapse, Bank of America Merrill Lynch index data show.

During the bond-market selloff this year, hedge funds fared better than broader market gauges. The funds declined 1.2 percent in June, less than half the 2.6 percent loss on dollar-denominated junk notes and the 2.4 percent decline for investment-grade and high-yield corporates globally, according to HFR and Bank of America Merrill Lynch index data.

‘Less Leverage’

“Hedge fund strategies look more conservative than what we saw pre-crisis, with larger cash balances and less leverage employed,” Andrew Sheets, a London-based credit strategist at Morgan Stanley, said in a telephone interview. “What is driving allocation into credit hedge funds isn’t really a reach for yield, but a search for volatility-adjusted returns.”

BlueCrest’s $1.9 billion Multi-Strategy Credit Fund gained 4.4 percent in the nine months through September, more than the 3.8 percent gain on the Bank of America Merrill Lynch U.S. High Yield Index in the period. Last year, the fund rose 7.2 percent, less than half of the 15.6 percent returns on dollar-denominated junk bonds.

“You’re seeing flows into credit-focused funds that can go long and short,” said Ken Heinz, president at HFR in Chicago. “Those flows are coming in at a time when interest rates are low and widely expected to increase.”

Fed Surprise

Economists who had forecasted the Fed to slow its bond purchases last month now expect the central bank to maintain the pace of the stimulus through the first quarter of 2014 after a 16-day government shutdown this month furloughed as many as 800,000 federal workers. The closing, which Standard & Poor’s said trimmed at least 0.6 percent from economic growth this quarter, also disrupted collection and publication of economic reports the Fed says it needs to determine whether the expansion is strong enough to taper.

Policy makers probably will pare the monthly pace of asset buying by 18 percent to $70 billion at their March 18-19 meeting, according to the median of 40 responses in a Bloomberg News survey of economists.

After the Fed’s Sept. 18 decision to maintain the purchases, corporate-bond yields that reached as high as 4.37 percent on Sept. 5 dropped to 3.9 percent, the Bank of America Merrill Lynch index data show. Yields are 1.9 percentage points below the 10-year average. In June, when yields rose 0.48 percentage points, the notes plunged 2.7 percent, the data show.

J. Crew Bonds

“People want to have strategies that look to preserve capital and profit modestly,” Hartford Investment’s Paolino said. “Most investors haven’t had exposure to a rising rate environment for a long, long time.”

Elsewhere in credit markets, J. Crew Group Inc. plans to sell $500 million of payment-in-kind bonds through its indirect parent to fund a payout to the retailer’s owners. Energy Future Holdings Corp.’s $3.81 billion term loan rose to the highest level in two months after Texas regulators supported a requirement that may lead to additional payments for the power generator.

The cost to protect against losses on corporate bonds in the U.S. was little changed. The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, increased 0.3 basis point to 72.1 basis points as of 11:12 a.m. in New York, according to prices compiled by Bloomberg.

European Index

The measure fell to 70.1 on Oct. 22, the lowest since November 2007 in data that adjust for the effects of the market’s shift to a new version of the index in September.

In London, the Markit iTraxx Europe Index of 125 companies with investment-grade ratings declined 0.7 basis point to 86.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bonds of Wells Fargo & Co. are the most actively traded dollar-denominated corporate securities by dealers today, accounting for 3.8 percent of the volume of dealer trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

‘Meaningfully Weaker’

The J. Crew parent, Chinos Intermediate Holdings A Inc. intends to issue senior notes due 2019, New York-based J. Crew said today in a statement. The offering would be the company’s biggest ever, exceeding a $400 million sale of 8.125 percent notes in March 2011, when shareholders approved a $3 billion takeover by TPG Capital and Leonard Green & Partners LP.

The company’s credit metrics “will be meaningfully weaker” than previously estimated because of the new debt, David Kuntz, an analyst at S&P, said today in a report ranking the new bonds CCC+ and lowering J. Crew’s outlook to “negative” from “stable.”

Moody’s Investors Service, which graded the new bonds Caa1, also cut its outlook for J. Crew’s family corporate rating of B2 to negative, saying in a report that the company will have “meaningfully less financial flexibility.”

Energy Future’s loan due in October 2014 jumped 2 cents on the dollar to 68.9 cents at 8 a.m. in New York, the highest since Aug. 22, Bloomberg prices show.

The Public Utility Commission of Texas agreed that it should mandate reserve margins, giving power companies access to extra electricity during times of peak demand, according to an Oct. 25 video of the meeting posted on the agency website. That may lead to the establishment of a so-called capacity market that pays generators for having available electricity.

Energy Future, formerly called TXU Corp. and taken private in 2007 by KKR & Co., Goldman Sachs Capital Partners and TPG Capital in the largest leveraged buyout in history, is locked in negotiations with creditors over a path to bankruptcy that would reduce its $43.6 billion in debt. Senior lenders are seeking a Chapter 11 filing before the company makes $270 million in interest payments Nov. 1 to junior bondholders.