Institutional Investor's Alpha Magazine - March 2008 - (Page 48) Fixed-Income Arbitrage times their capital. It’s a calculated risk, of course: Managers who trade virtually risk-free Treasuries can tolerate higher leverage. If they are playing on-the-run Treasuries (the most recent issues) against off-the-run securities (older issues of a similar maturity), extreme leverage may be acceptable because the prices must eventually converge. The strategy isn’t without risk, however, as the 1998 collapse of Long-Term Capital Management vividly showed. It’s what happens if spreads widen in the interim that concerns Vogt. He says the danger ratchets up for managers who use the arcane trick of trying to isolate the prepayment risk in mortgage-backed securities, another common fi xed-income arbitrage strategy. They can hedge interest rate risk by selling Treasuries short, but a credit crunch can cause losses on both long mortgage-backed securities — STEPHEN VOGT, CIO, and short gambits — as recent MESIROW ADVANCED STRATEGIES events have proved. “It looks like a nice, steady arb position, but you are long a mortgage and effectively short a Treasury of similar duration,” Vogt says. “In a flight to quality, everybody moves to Treasuries, and risk premiums widen on the mortgage side.” In a highly leveraged portfolio, it doesn’t take a big move to trigger margin calls and force a manager to sell positions at a loss. “Today,” Vogt says, “more-sophisticated leveraged relative-value trades are even more problematic, as financial crises can create a liquidity-driven sell-off in the higher-quality long position and covering of the poorerquality short position.” Investors learned that the hard way in blowups like LTCM and the one in February at London-based hedge fund Peleton Partners. The danger is far less severe for players in fixed-income arbitrage who focus only on a strategy involving interest rates, currencies and volatility but avoid credit risk. Brevan Howard Master Fund, the $17.5 billion flagship fund of London-based hedge fund manager Brevan Howard Asset Management, has about 80 percent of its assets in Group of Seven interest rates and foreign exchange. From inception in April 2003 through March 2007, the fund had a 10.5 percent annualized return after fees despite rising interest rates, flat yield curves and low volatility. When Brevan Howard raised $1.3 billion in an initial public offering of a feeder fund, BH Macro, listed on the London Stock Exchange in March 2007, the firm told investors — no promises, of course — that in more-favorable market conditions returns could exceed 20 percent. And so they did. When the credit markets began to unravel in June, the Brevan Howard Master Fund had the wind in its sails: From June through September it racked up monthly returns in excess of 2 percent, including a 5.97 percent return in September alone. The fund was up 25.21 percent in 2007, and the run continued into this year (it was up 9.89 percent in January and 7 percent in February). Performances like that don’t come from owning conventional bonds. Like most fixed-income hedge funds, Brevan Howard uses options, futures and derivatives to generate leveraged returns. And although the firm got the market spectacularly right, many fixed-income funds didn’t fare as well even if they shared the view that short-term interest rates would fall. Managers who chose to play the trend through LIBOR futures, for instance, were disappointed, as a global shortage of liquidity kept LIBOR high while both the overnight Fed fund and short-term Treasury rates tumbled. But arbitrage opportunities — as Jama and others note — abound in credit-sensitive instruments, too. Peter Hornick, head of U.S. collateralized debt obligations and structured credit at Lehman Brothers, says hedge funds were persistent sellers of “illiquidity premium” from 2002 through the middle of 2007: They typically bought subordinated bonds and sold senior debt as a hedge; bought single-name credit default swaps and sold an index short; or bought mezzanine layers of structured-credit vehicles and either sold the underlying single-name credits in the portfolio or bought puts on an index. Hornick says he sees a tremendous opportunity for hedge funds in the distressedstructured-credit market. Veteran distressed-credit players who know corporate capital structures have begun to build the technology to better analyze the holdings of CDOs, the pools of debt worst affected by the subprime meltdown. Today a hedge fund might buy the triple-A tranche in a CDO and short the single-A tranche as a hedge, for example. “In securitized vehicles you want to bet that losses will stop below where you are long but will impair where you are short in the capital structure,” Hornick explains. “Hedge funds are going to pounce on that.” The trick will be to finance the positions, and whoever gets there first will have a huge advantage. Meanwhile, some managers have discovered ways to generate double-digit returns in fixed-income arbitrage without huge leverage. David Edington, managing director and chief investment officer of Rimrock Capital Management in San Juan Capistrano, California, has developed an eclectic bifurcated portfolio structure, part of which extends fixed-income arbitrage to riskier positions that cannot support high leverage. To create what he calls an “income engine,” Edington buys short-term bonds that have maturities anywhere from nine months to three years, an overlooked sector that delivers most of the return available on longerdated bonds, with far lower volatility. “You get paid more than can be explained by risk premiums at the front end of the yield curve,” Edington says. “It’s an anomaly.” Short-dated bonds essentially eliminate the need for a quick exit strategy because Rimrock typically holds them to maturity. Edington, who has managed fi xed-income portfolios for more than 20 years, including a stint at Pacific In- “In a flight to quality, everybody moves to Treasuries, and risk premiums widen on the mortgage side.” 48 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2008
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