Fixed Income Hedge Fund Strategies

Hedge funds could perform fixed income investing as part of a broad multi-strategy investment approach.
i Jupiterimages/ Images

If you're thinking of investing in a hedge fund that uses a fixed income strategy, you shouldn't have any trouble finding what you're looking for. In 2012, hedge funds directed more than $40 billion into relative value strategies -- which broadly represents fixed income strategies -- surpassing the amount of money hedge funds invested in the stock market in that period, according to a 2013 Hedge Fund Research report. Unless you're investing in a hedge fund via a company-sponsored retirement plan, however, you must qualify as an accredited investor with a net worth of at least $1 million or an annual salary of at least $200,000 to participate in the hedge fund market. Plus, if a hedge fund has already reached its ideal size, you may be turned away.

Performance and Risk

By considering fixed income hedge funds, clearly you don't want to miss out on some of the best gains that the financial markets offer. In the three years leading up to 2012, for instance, fixed income hedge fund returns were more than double those earned by hedge funds investing in the stock market, according to a 2012 Barrons article. Nonetheless, it also helps to understand some of the risks involved with hedge fund investing. For instance, even though hedge fund performance may exceed other more traditional investments, fund managers pocket a higher percentage of the profits than average. The average hedge fund charges a 1.6 percent management fee plus nearly 19 percent of any profits earned, according to a 2012 New York Times article.

Swap-Spread Arbitrage

Some fixed-income strategies, such as hedge funds, are so risky, they're best reserved for professional investors. Fixed income arbitrage, which seeks to earn a profit from securities that appear to be wrongly valued in the market, is one such strategy. When the bond market took an unexpected turn in 1998, $7 billion hedge fund Long Term Capital Management came close to going under because of losing arbitrage trades. The U.S. government stepped in to prevent the hedge fund from failing amid fear that such an event would have had negative implications on the economy. While there are variations to fixed income arbitrage, one common approach hedge funds employ is to use proprietary research to place a gamble on whether interest rates for government bonds, such as U.S. Treasuries, will rise or fall.

Market-Neutral Funds

If the way that you're gaining access to a fixed income fund is via your employer's retirement fund, you have a good chance of being invested in a market-neutral fund. Retirement funds are increasingly looking to fixed income hedge funds to fulfill their target investments in fixed income securities, according to a 2011 "Financial Times" article. Hedge funds using market-neutral strategies invest in corporate bonds, betting that one of those bonds is undervalued and will increase in value while the other is too expensive and will fall in value. The savvy hedge fund then profits from the price difference between the two securities.

Mortgage-Backed Securities

When a homeowner defaults on a mortgage, it seems like it would be a lose-lose for everyone involved. Hedge funds, however, discovered a way to profit from such misfortune. Mortgage-backed securities are pools of mortgage loans through which investors claim a percentage of the income earned. In 2007, just as signs of the U.S. financial crisis were only beginning to surface, hedge fund Paulson & Company shorted sub-prime mortgages, which is to invest on the premise that sub-prime mortgage defaults would increase. The hedge fund successfully made the investment at the cusp of the sub-prime mortgage crisis and earned billions of dollars in the process, according to a 2011 Financial Times article.

the nest