Fixed Income Funds Have Been Underperforming, But Are Poised For A Turnaround

Investors are preparing for continuing high inflation by pouring money into fixed income and credit hedge funds. However, these funds are underperforming the markets despite all the investor inflows they have been capturing.

A semi truck drives past a price board at a Shell gas station near a church in Alexandria, Virginia … [+] on November 23, 2021. – With inflation surging ahead of the Thanksgiving holiday, US President Joe Biden has drawn on the seldom-used Strategic Petroleum Reserve to combat rising oil prices that have fueled the recent spike. (Photo by ANDREW CABALLERO-REYNOLDS/AFP via Getty Images)

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Fixed income underperforms most other strategies

According to With Intelligence, the HFM Fixed Income/ Credit Index declined 0.3% in October due to widespread volatility in the bond market. That return was bad enough to make the strategy the worst-performing strategy for the month. The other bottom three strategies during October were macro index funds, which were flat in October, and multi-strategy funds, which returned 0.6%.

On a year-to-date basis, fixed income and credit funds are up only 5.3%, with macro funds being the only strategy to post a worse performance at 3.7% year to date. Meanwhile, the HFM Global Composite Index is up 10.2% year to date.

The event-driven strategy is the strongest performer year to date with a 13.9% return, followed by equity index funds at 11.8% and multi-strategy funds at 10.3%. For October, managed futures index hedge funds were the best performers with a 2.2% return, followed by event-driven funds at 1.8% and funds of hedge funds at 1.6%.

While the bond market volatility weighed on fixed-income funds, it was good news for CTA funds. CTA trend followers continued to profit from significant price moves in the energy markets and other systematic strategies. In October, Quant fund Quest Partners returned 7.7% in its $1.9 billion AlphaQuest flagship fund, bringing its year-to-date return to 19%.

Investors and fund managers tricked by macro conditions

With Intelligence explained in a recent report that significant volatility in the bond market captured many hedge funds in its net. Growing expectations of central banks tightening their monetary policies have caused investor expectations to shift.

Investors and fund managers incorrectly forecasted shifts in government bonds, resulting in losses at the yield curve\’s long ends. Due to these incorrect forecasts, most fixed income hedge funds ended October in the red. Additionally, some macro specialists with strong brands racked up some high-profile losses for the month.

The best-performing fixed-income hedge fund so far this year is Old West Investment Management, with Wasserstein Debt Opportunities Management and Highland Capital Management filling out the top three spots in the strategy. Hildene Capital Management, Waterfall Asset Management and King Street Capital Management are the leading fixed-income funds with over $1 billion in assets under management.

81% of fixed income/ credit hedge funds have posted a positive year-to-date performance through October, compared to 75% of all hedge funds and 87% of funds of funds. The firm added that the volatility in the bond market in October took out many high-profile macro specialists. Rokos Capital lost 18%, while Element Capital was struck by a $1 billion loss on a wrong-way bet on U.S. government bond yields. Additionally, Alphadyne posted a return of about -7% for October.

Investor flows were positive for fixed income funds despite underperformance

Although the average fixed-income fund posted a negative performance for October, it still recorded inflows from investors, pulling in a net $3.7 billion. However, the strategy is in the red for flows year to date, having recorded $2.3 billion in net outflows. All other strategies except for macro and multi-strategy funds have recorded double-digit billion-dollar inflows.

Current macro conditions should be a boon for fixed income funds despite their weak performance in October and year-to-date outflows. The firm noted that the benchmark 10-year U.S. Treasury yield peaked in May but has surprisingly remained steady through the second half of the year.

Many investors had been expecting a sharp drop in the yield and positioned their portfolio based on that expectation. Directional bets on the 10-year Treasury yield have driven the performance of fixed income and credit hedge funds so far this year. It expects this trend to continue for the rest of the fourth quarter.

43% of fixed income and credit hedge funds posted positive inflows year to date through October, compared to half of all hedge funds. However, October put flows among fixed income and credit funds back into the green over the last 12 months, with the strategy recording $1.2 billion in net inflows over the last 12 months.

New regulations for U.S. government bond trades in discussion

The movements in the bond market have led Securities and Exchange Commission Chairman Gary Gensler to consider more central clearing of all U.S. government bond trades. However, the firm added that it\’s unclear how new regulations and oversight would stabilize and correct flaws in the market or whether they would risk more underperformance.

The $22 trillion U.S. government bond market is the foundation of the global capital markets, and regulators have considered changes to regulations for some time. The most recent trigger for the consideration of a new, more centralized framework was the bond markets\’ sudden surge in activity in response to the pandemic in March 2020.

When COVID-19 reached Europe, investors panicked, converting their holdings into cash and causing dealers to be unable to process the extreme demand for Treasury sales. The Federal Reserve eventually bought up large quantities of Treasuries to reduce the pressure and try to reinstate the Treasury market\’s position as a home of safe-haven investments.

Skepticism among hedge funds

Most hedge funds are skeptical of the regulatory narrative because the Treasury market\’s dysfunction exacerbated the situation. The firm added that new regulations would give preference to proprietary trading funds over legacy investment banks, which currently dominate the market.

Combining high-speed trading with strict regulations on leverage has reduced the influence of investment banks despite the exponential growth in U.S. debt. In recent weeks, liquidity has deteriorated, and investors have been attempting to exit their bearish positions on longer-dated Treasuries. The move comes despite the U.S. employment report in October, which indicated robust jobs growth, and the continued increases in stock prices.

With Intelligence pointed to elevated levels of distress, volatility and mispricing as signs that fixed income and credit investors who have struggled in recent months will see improved performance.