Fixed Income Arbitrage Thrives As Bond Yields Rise

Bond yields continued to edge higher over the recent weeks on the back of stronger economic data and higher inflationary pressures. The rise in bond yields was more pronounced in Europe than in the U.S. across the curve, which contributed to the appreciation of the Euro vs. USD in January. This environment has proved supportive for risk assets in the U.S. and emerging markets.

With regards to hedge fund performance, Global Macro and CTA managers experienced negative returns in January due to long USD positions, especially versus the Euro.

Meanwhile, Fixed Income Arbitrage, L/S Credit, and Event-Driven managers outperformed both last week and in January overall. In the previous edition of this report we discussed the outlook for Event-Driven in light of the solid pace of M&A activity in the health care sector. Last week, we focused on Fixed Income Arbitrage, a strategy on which we reiterate an overweight stance.

Fixed Income Arbitrage and L/S Credit funds have been supported lately by both alpha and beta components. The rise in bond yields has created arbitrage opportunities such as the deviation between cash and futures bond prices (the so-called basis).

Beta conditions were also supportive as high yield spreads tightened in January. A simple quantitative exercise suggests Fixed Income Arbitrage indices deliver positive returns when bond yields rise. As a result, the strategy currently appears to us to be attractive to protect portfolios. In that regard, we believe 10-year Treasury yields could reach 3% by the end of 2017.

Finally, L/S Credit funds also delivered healthy returns in January, especially Asian managers. While we are cautious on directional L/S Credit funds going forward, we believe that relative value players can continue to deliver healthy returns.

According to Moody’s, default rates for speculative grade issuers in 2017 are expected to decline in the U.S. and to remain low in Europe as economic activity gathers momentum.

And while it remains unclear whether credit spreads can continue to tighten if sovereign bonds face additional headwinds, we believe relative value L/S credit managers should be able to generate value.