Cracks in corporate debt markets are testing the “hedge” in hedge funds.

Funds managing pools of debt buoyed by years of easy money policies now face the possibility of a downturn. Stock market volatility has filtered through to credit issuers, causing corporate bond and loan prices to experience their worst price drops in years. Hedge funds, which have shied from outright bets on corporate debt, are finding themselves at a crossroads—buy the dip or double down on defensive positions.

“What’s happened is that the prolonged, years-long zero interest rate regime changed what regular late cycle behavior in the credit market looks like,” said Charmaine Chin, a managing director at K2 Advisors who invests in credit hedge funds.

Credit managers typically hold investments for shorter durations than their peers, while also betting against companies using credit default swaps and other derivatives. They have been a relative bright spot for the hedge fund industry this year, making returns of 4.60% through November, according to the Absolute Return Credit Index.

But ballooning levels of corporate credit has caused concern among some investors, especially in riskier securities such as high-yield bonds and leveraged loans. Paul Tudor Jones recently warned rising interest rates could “stress test our whole corporate credit market for the first time.” The extra yield investors require to hold junk bonds over U.S. Treasurys rose above 4.5% in December on an options-adjusted basis, according to Bank of America Merrill Lynch data, the highest in two years.

GoldenTree Asset Management, the $28 billion manager, increased the use of hedges in its flagship credit hedge fund during the third quarter, including a short position in the junk bond market. The fund closed some of those positions as stocks and bonds sold off in October, it said the following month.

Chris Hentemann, founder of the more than $2 billion credit hedge fund 400 Capital Management, said the corporate sector is the most at risk of the three he follows. 400 invests in structured credit backed by consumer, corporate and real estate debt, including bundles of leveraged loans.

“Corporate credit is probably the most advanced in the cycle,” Hentemann said. “At underlying credit issuers, the leverage looks the most aggressive.”

Hentemann has added to short positions in recent months, reducing the fund’s market exposure. “We are taking certain tactical short positions in more levered names in subsectors that we think will be more sensitive to a slowdown,” he said.

Short interest in the two largest junk bond exchange-traded funds, HYG and JNK, reached more than $10 billion this month, according to IHS Markit data. Traders borrowed 60% of outstanding shares in HYG on December 10 for shorting, according to the data, the most this year.

The borrowing could be part of a strategy meant to take advantage of mismatches between the funds and their underlying assets. One popular trade involves buying a high yield index using total return swaps and selling the corresponding ETF.

Even then, the short interest reflects a broader caution in corporate debt markets. A large number of corporate bonds rated BBB, the lowest grade for “investment grade” credit, trade at distressed levels. Those bonds make up roughly half of the investment grade market, but could become junk if economic conditions worsen, according to analysts.

Canyon Capital Advisors has invested most of its flagship hedge fund in equities this year, seeing few opportunities in corporate credit markets, according to an investor document from after the first quarter. The firm managed $18.3 billion in hedge funds in July.

Angelo Gordon & Co., which managed $12.7 billion in hedge funds at midyear, has shortened the duration of its holdings this year while focusing on bonds with greater protections. “With a significant majority of the portfolio invested in hedged or liquid positions, we believe it is well suited to capitalize on intermittent volatility and oscillating price action,” the firm wrote to investors in its Super fund.

The more than $20 billion credit manager Sound Point Capital Management has also avoided long duration bonds, it wrote in a letter to investors last month. Sound Point said the Federal Reserve’s unwinding of post-crisis easy money policies has thrown markets into “unchartered territory.”

“This leads us to portfolios that, on the long side, are weighted heavily towards the top of the capital structure and light on unsecured high yield bonds,” Sound Point wrote. “Where we are invested lower in the capital structure, these positions have near-term events.”

Still, some hedge funds used the sell-off in October and November to buy beaten down credits, investors said. Sir Michael Hintze, founder of the British credit hedge fund CQS, said this month he views the BBB market as “crowded” but has found opportunities in certain unloved credits.

“We are finding value in heavily shorted names that are priced like BBs that we believe have the desire and ability to deleverage,” Hintze wrote in a research note. “We favour companies that are well managed, have strong cash flows and plenty of assets to sell to de-leverage and we have been adding positions both on the long side and the short side.”

Even then, this month’s bond market stress could eventually give way to a larger downturn, investors said.

“The hedge funds that were short rates and very defensively positioned a few years ago suffered in terms of relative performance,” Chin said. “…They’ll be right eventually, and I think if you were positioned that way this month you were cheering.”

 

 

Bond market pain stress-tests credit funds on Absolute Return.