London (HedgeNordic) – Brummer & Partners-backed Frost Asset Management’s Scandinavian-focused fixed-income relative value fund is closing down after incurring a loss of 17.6 percent in October. The fund had only launched in January of 2020.
But this was just the most notable and prominent victim in the Nordics. Indeed, a number of fixed income arbitrage strategies including mortgage arbitrage, inside and outside the Nordics, as well as global macro funds that trade relative value fixed income, have seen notable performance losses of between 5% and 20% for the year to date. The closure of Frost comes after a period in which most fixed income relative value strategies have seen below average returns, with a handful of managers in the NHX Fixed Income index approximately flat for 2021 as a whole. (This index also includes directional and long biased managers taking corporate credit risk, who have generally performed better this year).
Fixed income arbitrage managers tend to be interest rate neutral, and instead some of them may trade the yield curve shape, or various spreads between different markets such as callable and non-callable mortgages, swaps, inflation linked bonds, government bonds and sometimes cross currency swaps. Though higher inflation and interest rates seen in 2021 may not always have any direct impact, they can have an indirect impact – by dislocating the relative value relationships.
For instance, Frost mentioned yield curve flattening in Sweden, though this phenomenon was not unique to the Swedish fixed income markets. Managers active in the UK, US and Asian fixed income markets have also reported losses after their yield curve steepener trades were wrong-footed by the yield curve moving in the opposite direction. The Bank of England has especially disappointed those managers who expected early UK rate rises, which at one stage became a consensus view factored in to the forward markets.
Volatility and Swap Spreads
The yield curve trades have been most widely reported but are not relevant for all fixed income arbitrage strategies. Not all of them trade the yield curve and even amongst those that do, not all of them had steepener trades on in 2021.
There have been other challenges for fixed income arbitrage strategies. Many of the Danish mortgage funds had a difficult first half of 2021 as Danish callable mortgage bonds underperformed, and this is often related to interest rate volatility. Some sub-strategies investing in mortgage bonds are in effect short of volatility, sometimes because they are wagering on mean reversion and in other cases because they are short of the embedded prepayment call option in mortgage bonds. Interest rate volatility has therefore been adverse by increasing the value of this optionality. While equity market volatility has been relatively subdued, interest rate and swaption volatility has been high.
Another headwind for some strategies has been higher asset swap spreads, and higher spreads between interest rate swaps and government bonds. There is speculation that widening in shorter term asset spreads could be related to a shortage of collateral, partly because the European Central Bank has now bought so much of it. Asset purchases may be an obvious benefit for long biased managers but if too much liquidity is sucked out of the markets more sophisticated strategies might run into some road bumps.
Liquidity, Leverage and Liquidations
There have also been reports of liquidity bottlenecks in forward interest rate markets. Thin markets can lead to exaggerated moves, as can the substantial leverage use by some managers. This might be 3 or 4 times when calculated to be equivalent to a ten year government bond, but it could be multiples of that in nominal terms. There is speculation that margin calls on leverage might have forced some liquidations, though it is also probable that managers’ own risk management limits would have kicked in well before any counterparty related limits. Many managers try to keep volatility in a range so will need to scale back exposure if their volatility spikes up. This illustrates how the industry has matured over the past 20 years. Back in 1998, Long Term Capital Management famously blew up due to some leveraged mean reversion trades in bond markets. Though some managers’ recent 20% losses may seem like a shock, on a ten year view they have still generated very strong risk adjusted returns.
Positive Returns and Bullish Outlook
Several fixed income relative value funds are still positive for 2021 calendar year to date however. “The last 3-5 weeks have been a difficult period for many Fixed Income Hedge Funds. Many funds are in negative territory, and several Fixed Income Hedge funds with double digit negative returns. Therefore, I am also happy to have all 3 Danske Bank Asset Management Fixed Income Hedge funds in positive territory for the year – even though we have also seen some headwinds in the last 3-5 weeks,” says Michael Petry of Danske Asset Management. These three funds Danske Invest Fixed Income Global Value, Danske Invest Fixed Income Relative Value, and Danske Invest Hedge Fixed Income Strategies – report data to the HedgeNordic NHX Fixed Income index.
“The last 3-5 weeks have been a difficult period for many Fixed Income Hedge Funds. Many funds are in negative territory, and several Fixed Income Hedge funds with double digit negative returns.”
Going forward from here, the outlook now seems positive. “The volatility during the last couple of weeks have given a number of new opportunities and I am therefore optimistic for the upcoming year – and more optimistic than a year ago,” says Petry.
Some managers are very excited about their prospects. One told us that,”given the mean reversion nature of our strategy, this has thrown up a huge opportunity set. The fund tends to perform best in periods of uncertainty and as can be seen, the strategy has had some of its best periods of performance post dislocations such as 2008. Should volatility pick up we can easily achieve 10% returns or more. The bounce back can be very strong”.
“Buying the dip” has become a meme for equity markets and if we review the long term performance of Nordic fixed income arbitrage managers, those who bought into previous drawdowns were generally rewarded with above average returns. Both the strategy and the return profile of the managers have shown a pattern of mean reversion that bolder investors may be keen to take advantage of.
This article features in HedgeNordic’s 2021 “Alternative Fixed Income” publication.