In a year of uneven returns for many U.S. hedge funds, managers who invest mainly in bonds have outshone stockpickers.
Over the first five months of the year, credit-focused hedge fund portfolios were up 4.11 percent compared with a 2.4 percent gain for stock-focused ones, according to hedge fund tracking service eVestment|HFN.
Well-known managers like David Tepper and Daniel Loeb have seen hefty returns in their credit-focused portfolios on bets they made in the second half of 2011.
Some managers are profiting from those shrewd trades, which they made on mortgage-related securities, U.S. corporate debt and beaten-down European sovereign and corporate bonds. Others, meanwhile, benefited from an early move into junk bonds, which have been one of the credit market's better-performing sectors this year.
It is another indication that in a year of great turbulence in the stock market, bonds have been the place to be despite the yield on the 10-year U.S. Treasury hovering around 1.61 percent.
"At the end of last year, European financials were massively battered down so we went long those corporate credits - they were great investments," said Peter Faulkner, a credit portfolio manager at $2 billion P. Schoenfeld Asset Management.
Similarly, Third Point's Dan Loeb, in a May 4 investor letter, said successful bets on corporate credit during a debt market selloff last October, led to strong gains on those positions in the first quarter.
PSAM's credit fund, which was up 6.6 percent through May according to HFN, also benefited from gains in corporate credits that have exposure to U.S housing such as iStar Financial Inc and Residential Capital LLC.
James Malley, who co-manages the PSAM credit fund with Faulkner, likened the fund's gains this year to "harvesting" investments it made last year.
The PSAM fund profited, in part, from the European Central Bank's move to pump more money into the euro zone banking system earlier this year in an attempt to stabilize the economic situation. The effort temporarily boosted liquidity and confidence, which led to a rise in corporate bond prices around the globe.
Also funds that were early to buying high-yield debt benefited from a growing sentiment that corporate defaults were unlikely given signs of a strengthening economy and a search by investors for securities that yield more Treasuries.
But the high-yield market has given back some of this year's gains in the wake of recent weaker jobs data and renewed worries about Europe.
ROUGHER ROAD AHEAD?
This year retail investors have made a similar big move into bond mutual funds, as they flee stocks and seek to avoid risk. Through May, bond mutual funds gained $139.84 billion in net inflows, while equity mutual funds saw $27.21 billion in net outflows, according to estimated data from the Investment Company Institute.
But some analysts wonder whether the big gains for credit funds in the hedge fund universe have already been achieved for the year. These analysts suggest it will be much tougher for debt funds going forward with yields on high-quality corporate debt declining and an uptick in U.S. home foreclosures that could spell trouble for mortgage-backed securities.
"Most of the positive year-to-date performance in credit strategies can be attributed to January through March," said Minkyu Michael Cho, a research analyst at eVestment|HFN.
In May, credit-focused portfolios fell 0.02 percent, according to eVestment|HFN. But that was not as bad as the sharp 3.31 percent decline registered by stock-focused funds in May.
Still, the credit market also has proved to be a bumper crop for Tepper's Palomino fund, which is one of the largest portfolios managed by his Appaloosa Management. The $5 billion credit fund rose 12.94 percent through April 30, according to data collected by HSBC Private Bank.
Another top performer is Andrew Feldstein's Bluemountain Credit Alternatives Fund, which was up 7.85 percent through May 25, according to HSBC data.
The Brevan Howard Credit Catalysts Fund has risen roughly 6.5 percent through May 25, and a CQS ABS Feeder Fund had gains of almost 5 percent through April 30. Meanwhile, the Mariner-Tricadia Credit Strategies fund was up 5.14 percent through May 15.
The standout performance by credit-focused funds has helped some managers offset sharp losses in their stock funds. One example is John Paulson, whose flagship Paulson Advantage fund is down 6.3 percent this year, while Paulson & Co's Credit Opportunities Fund is up 5.26 percent.
Distressed credit fund Pamli Capital Management, which earned big gains earlier in the year on trades in mortgage-backed securities, has risen 1.6 percent for the year, according to an investor note.
But eVestment's Cho said with yields coming down on high-grade U.S. corporate debt and Treasuries, the easy money may have been had.
"It seems the move to safer assets may actually have hurt credit strategies over the course of the year," he said. "Yields have come down across the board for U.S treasuries since highs in March, and yields have also come down for U.S. AAA corporates."
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