Opportunities for Alternative Relative Value Fixed Income Strategies in a New Market Cycle.
2023 continues to be the year of a new paradigm shift for global financial markets with central banks tightening liquidity and increasing lending rates to fight rising inflation.
With a high correlation between traditional asset classes such as equities and bonds, as seen by the poor performance of the typical 60/40 balanced portfolio in 2022, investors have had to reassess their asset allocation and balanced portfolio models into 2023. In this context, liquid alternative investment strategies with diversified and uncorrelated sources of return, such as Hedge Funds, (particularly those whose sources of alpha stream from capturing mispricing opportunities in asset prices such as Fixed Income arbitrage and Long/Short investment strategies) are providing investors with a relatively attractive investment solution.
Furthermore, the high-interest rate setting is also beneficial to alternative (Long/Short) investment strategies as the embedded cost in constructing the hedging (or ‘short’ portfolio) is not only significantly lower but, in fact, beneficial to the investment strategy, thus increasing the strategy’s net absolute return. The key is that the increase in overnight rates leads to an increase in return expectations for relative value strategies. A negative rates environment is a drag to any Long/Short strategies but a positive rates environment, translates to an additional marginal performance of around 2-3% annually.
The end of 2022 and the beginning of 2023 saw a return in ‘risk-on’ appetite among market participants and asset owners, as higher interest rates in the US and European corporate bond issuers attracted massive inflows as investors looked to lock in the higher income on these high-quality corporate bond issues. These inflows have led to record tightening levels in IG (investment grade) and HY (high yield) credit spreads across the board. However, as the 2022 companies’ incomes and forward-looking earnings were released between February and March 2023, we are seeing an increasing number of companies feeling the pressure on their balance sheets. And refinancing capabilities (with much corporate debt refinancing due in 2024-2025) are driving a sharp increase in dispersion between companies’ share price performance and in corporate bonds’ performance, particularly in Europe where the credit markets are less efficient than in the US. We expect this dispersion to increase further in the next couple of years as financially weaker issuers will have to refinance at higher borrowing rates.
Hence, there is a strong case for market-neutral, relative value strategies in 2023. As we have seen so far in 2023, market expectations and narratives are extremely volatile and can swing wildly. In January, the narrative was fast falling inflation expectations leading to Fed pivot and market optimism. In February, the narrative, just like a pendulum, quickly swung the other way with seemingly persistent high inflation leading to more rate hikes with the Fed and ECB. Furthermore, when everything appears calm and constructive, there are always unidentified unknowns that may promote significant downside risk factors especially when valuations are stretched and the reward for holding risk is poor. Case in point, most recently in March we saw the collapse of SVB bank and uncertainty over the fate of Credit Suisse leading to extreme moves in the rates market as well as wider risk premium overall.
Market-neutral relative value strategies are well-placed to protect investors in market volatility compared to outright investments. We believe that the current environment is extremely positive for active and long/short alternative investment managers, whose objectives are to generate alpha by identifying mispricing opportunities in the corporate bonds markets.
We strongly believe that 2022 was just the beginning of a new market paradigm in the corporate bonds markets, where we expect to see higher volatility and dislocation among European credit issuers going forward. We remain focused on navigating these turbulent waters and managing risk on behalf of our trusted clients, by always seeking market neutrality, and generating positive absolute performance.
The Redhedge Team
20th March 2023
Disclaimer: This document is intended for Professional, Sophisticated Investors only. This document does not constitute any kind of financial, legal or tax advice. We assume no liability for the completeness, timeliness and/or accuracy of the content. Use of the information and evaluation of the merits and risks of the same, remains solely at your discretion. Investment involves risk and is not suitable for everyone.
Redhedge is authorised and regulated by the Financial Conduct Authority; Firm Reference Number 660296.
Redhedge Asset Management LLP, 3rd Floor, 43 Grosvenor Street, London. W1K 3HL
020 3940 5626