Innovative funds can hedge fixed -income volatility

As you watch your bond investments stumble against rising interest rates, you're probably on the lookout for fixed income options that aren't so interest sensitive.

As it happens, two of Canada's best-known hedge fund providers offer innovative fixed income funds that afford some protection in just this situation.

Picton Mahoney Asset Management's Income Opportunities Fund and Gluskin Sheff + Associates Inc.'s Credit Arbitrage Fund are designed to try to generate moderate and relatively steady returns similar to traditional bond funds, but without the traditional bond fund's notorious vulnerability to rising rates. However, they carry other risks, and are typically available only to wealthier investors.

"We think conventional fixed income investors who are buying long only bonds are at more risk than they've been for many, many years," says William Webb, chief investment officer at Gluskin Sheff, which was established in 1984 and has $6.1-billion in assets under management.

"Your traditional bond investments are going to have a tough time delivering going forward," says Philip Mesman, portfolio manager fixed income at Picton Mahoney, established in 2004, with $7.2-billion in assets under management.

Some hedge funds use large amounts of leverage to pursue sky-high returns at great risk. However, these are among the relatively conservative funds that follow the original hedge fund concept of pursuing moderate returns while hedging against risks that aren't easily covered by conventional stock and bond investments. Mr. Mesman describes them as "authentic hedge funds." As is typical for hedge funds, they charge higher fees than most conventional fixed income mutual funds.

Bond prices move inversely to interest rates, so prices fall when rates rise. Both these funds buy and hold bonds they think are relatively attractively priced (known as "long" positions) and then sell bonds "short" that they think are relatively unattractively priced, so as to roughly balance overall interest rate sensitivity on both sides. That way, if overall interest rates go up or down, the price impact on the long bonds is roughly offset by the opposite price impact on the short bonds.

With the help of a moderate amount of leverage, the fund portfolios are constructed so that the long bonds generate more yield than the short bonds, resulting in built-in yield on a net basis. In addition, some bonds will perform better than others for reasons other than overall movements in interest rates. These funds make a bit more money if the long bonds they hold perform relatively well compared withthe bonds they've shorted – in other words if interest-rate spreads narrow between the two. But they also run the risk of losing money if spreads widen or the long bonds they hold run into serious credit problems.

While overall strategies are somewhat similar, Gluskin Sheff holds investment-grade corporate bonds long and shorts high-grade government bonds. With relatively little default risk involved, their strategy depends to a large extent on buying relatively well-priced corporate bonds and then harvesting the interest rate spread that generally occurs between corporate and government bonds, without those spreads increasing.

They believe the risk of spreads widening is relatively modest because those spreads are fairly wide by historical standards. If anything, they think spreads will tend to narrow somewhat over time. Gluskin Sheff introduced this fund at the start of 2009. The firm doesn't offer individual funds directly to investors, but manages portfolios for high net worth investors with at least $3-million to invest.

In contrast, Picton Mahoney holds high yield as well as the lower end of investment grade corporate bonds in both long and short positions, in addition to shorting government bonds. With many lower-rated bonds, its strategy tends to rely more heavily on making good individual credit assessments both long and short. "We're credit pickers," says Mr. Mesman.

Among his favorite long positions, Mr. Mesman currently holds relatively short-term corporate bonds that were issued two or three years ago when market conditions required lots of security and protective bond covenants. Current "shorts" include bonds of gold mining companies as well as recently issued high-yield bonds that seem to be "priced to perfection," he says. "I'm an old school credit guy and the idea of lending a high yield company money at 5 per cent for 10 years never made sense to me."

Picton Mahoney launched this fund at the start of 2010 and offers it through investment advisers. The minimum initial investment is $25,000 in British Columbia, New Brunswick, Nova Scotia, and Newfoundland in the less regulated "exempt" market. But in other provinces investors need to invest $150,000, or have sufficient wealth to warrant "accredited investor" status, due to provincial securities legislation.

In each case, these hedge funds are normally held in diversified portfolios alongside conventional stock and bond investments. Mr. Mesman says investors typically allocate 10 to 15 per cent of their fixed income allocation to his fund. "I think we complement a traditional bond strategy," he says.

At Gluskin Sheff, for a typical investor's portfolio, the firm allocates roughly 25 per cent to alternative fixed income strategies including the Credit Arbitrage Fund and only 10 per cent to conventional "long-only" fixed income investments, says Mr. Webb. It also invests 25 per cent in alternative equity strategies and 40 per cent in conventional "long-only" equities.

In recent years, both funds have often done reasonably well when overall investment grade bonds are performing poorly and vice versa. This year they've been off to a decent start – year-to-date returns net of fees are 3.3 per cent with Gluskin Sheff's fund and 1.8 per cent with Picton Mahoney to the end of June. That compares well to the DEX Universe Bond Index, a broad measure of the Canadian investment-grade bond market, which is down 1.7 per cent in the same period. Both funds had double digit returns in 2012, but lost a small amount of money in 2011.

David Aston, CFA, MA, is a freelance writer specializing in financial topics.

David Aston, CFA, MA, is a freelance writer specializing in financial topics.