Bond "dislocation" arbitrageurs back in the money

Date: Thursday, November 10, 2011
Author: Tommy Wilkes

(Reuters) - A controversial hedge fund strategy that played a role in the demise of Long Term Capital Management may be one of the few to make money this year after managers who pursue it made their bets smaller and shorter term.

The small handful of remaining fixed income relative value funds, which find price "dislocations" in bond markets and then bet they will correct themselves over time, are profiting from recent volatility in the U.S. and Europe.

The dislocations are usually small, so funds rely on borrowing -- in the past as much as 40 times their assets -- to boost returns, making it a high-risk strategy if markets turn and funds are forced to sell at a loss to meet margin calls.

This year managers have slashed leverage and are choosing quick, tactical, bets instead of bold punts, helping most to outperform rival strategies and avoid the pitfalls of 2008 when several high-profile names crashed out.

"The U.S. went from 'the world is safe and booming' in the first quarter of this year to 'we have fallen off the edge of the cliff and we are going to double dip'," Basil Williams, CEO at $1.1 billion hedge fund Concordia Advisors, said.

"I think there is going to continue to be a healthy level of volatility."

Connecticut-based Long Term Capital Management, founded by bond trader John Meriwether, nearly collapsed in 1998 after the hedge fund's highly leveraged dislocation bets turned sour during the Russian financial crisis, forcing it into a bailout to prevent wider market turmoil.

Trading the U.S. Treasury market since the Federal Reserve started buying long-dated bonds in its "Operation Twist" has proved one of the most profitable trades, managers say.

The HFRI Relative Value (Total) Index is 0.93 percent ahead in 2011, versus a 3.5 percent drop in the HFRI Fund Weighted Composite Index, though some big-name funds are up by much more.

Field Street Capital Management's $910 million fund is up 5.75 percent, while the $6.8 billion Capula Global Relative Value Fund, the world's largest fixed income arbitrage fund, grew 5 percent to October 31, a source familiar with the fund said.

A spokesperson for Capula declined to comment.

Some funds which use relative value trading as part of package of strategies are also faring well.

The $9 billion BlueCrest Capital International Fund, a macro fund with a focus on fixed income, is up 4.6 percent, a source familiar with the fund said. Bluecrest declined to comment.

NICKEL AND STEAMROLLER

Rod Gancas, New York-based Field Street's CIO, said the extent of market uncertainty -- and volatility -- this year had kept returns lower than they otherwise would have been.

"If I were looking from the outside in and I just looked at some of the opportunities I might have guessed this should be a 15 percent return type of year...(but) you have to ask yourself, 'How much alpha can you actually get out of the market? What's appropriate to shoot for in a market?'" he said.

Yet for the few still keen to brave the strategy -- once likened to picking up nickels in front of a steam roller -- a vastly shrunken pool of competitors should help returns.

Many funds shut up shop after 2008 losses and bank proprietary desks, traditionally large players in the sector, stopped using their own capital to bet.

Europe, where a two-year debt crisis and European Central Bank action has produced marked volatility in government bond prices, could offer some of the best future opportunities, though many managers are cautious until the crisis stabilizes.

"There are real macro stresses and some of the little dislocations in Europe might be meaningless if we are headed down the path we appear to be heading down," said Jeff Majit, head of European hedge fund investments at Neuberger Berman.

Concordia's Williams said despite the uncertainty he is trading the difference between sovereign rates and swap spreads, eyeing mispricing in the risk of government debt versus the debt of banks based in the same country.

"Certainly when you are in a market where none of the 17 member participants control the printing press of the Euro it's a much more dicey relationship to trade," he said.