Monday, April 28, 2014

"Rising Interest Rates Will Hurt These Hedge Funds"

From Barron's:
Talk to Andrew Silton for five minutes about hedge funds and you may want to sell every one you have. The retired chief investment advisor of North Carolina's pension plan thinks many funds will be in for a world of hurt once interest rates rise. And with the Federal Reserve winding down its bond-buying program, he thinks that rate spike is coming soon. "Hedge strategies that work 90% of the time could have serious problems," he says.

The structure of hedge funds presents unique challenges. Because hedge fund fees -- typically 2% of assets and 20% of profits -- are so high, managers often employ leverage to juice returns. This amplifies the exposure to rate-sensitive securities, and also creates a cost structure that increases along with rates -- they're borrowing at higher rates -- when their portfolios could be the most vulnerable. For this reason, Silton, in his Meditations on Money Management blog, has urged his fellow pension managers to rethink their hedge-fund positions.
Not only does the cost of leverage increase with rates, but the amount of collateral brokers demand from funds increases, as well. That forces fund managers to sell off their portfolios to reduce their leverage and meet margin calls. In a falling market, the end result could be a snowball effect for their most illiquid stocks and bonds.

Ironically, Silton thinks the hedge funds most vulnerable to a rate shock today are those designed to avoid it. Many fixed-income hedge funds buy high-yield bonds and short Treasury bonds as a defense against rising rates -- historically, the higher yields on junk bonds provide enough of a cushion to withstand rate increases. In 2009, for instance, junk yields got as high as 20%, while Treasuries paid almost nothing. No interest-rate increase will damage a 20-point yield spread. But today, high-yield bonds pay less than four percentage points more than Treasuries—a tight spread that will probably blow out if rates rise. For one, yield-hungry investors will start to view Treasuries as more attractive relative to other bonds. Two, default levels for junk bonds could increase as overleveraged issuers refinance at higher rates, putting pressure on the sector. Meanwhile, hedge funds will face margin calls from their brokers, higher financing costs, nervous investors, and the challenge of selling illiquid junk bonds in a falling market.

Some hedge-fund experts are already lightening up on their bond-fund exposure. "We have probably the lowest weighting in credit hedge funds in years," says Dan Elsberry, senior managing director of K2 Advisors, a subsidiary of Franklin Templeton that has more than $10 billion invested in hedge funds. "As rates pick up, it will be much better on the long-short equity side than the credit side." ...MORE