An improving U.S. economy has led the Federal Reserve to taper its purchases of Treasuries and mortgage backed securities. As this significant source of demand leaves the market, interest rates could continue to move higher, creating a headwind for duration assets.
For a preview of what this may look like for fixed income investors, we need not look far. Between May and early September 2013, fixed income (as measured by the Barclays U.S. Aggregate Index) experienced its second largest drawdown (–4.87%) since 1990 and, as a result, investors pulled $40bn from bond funds and ETFs.
We believe a potential solution for investors looking to decrease duration risk may be to allocate to hedge funds.
While we continue to believe that core bonds are a critical element of a prudent investor’s portfolio, we have seen considerable interest from clients exploring alternatives to fixed income—including hedge funds—in order to reduce interest rate risk. In this paper, we explore the merits of this idea, by examining the impact that rising interest rates may have on core fixed income, comparing the performance of hedge funds and fixed income in rising rate scenarios, and summarizing the outlook for hedge fund investments. Finally, we describe how clients are implementing this opportunity in portfolios.