Falling bond markets could see investors redeem large amounts

Investors could redeem large amounts from fixed income hedge funds soon after the recent bond market falls, both due to funds' performance being wiped out and a healthier economic outlook, according to fund managers.

David Smith, chief investment officer at GAM, said the recent sell-off and volatility could pose a serious longer-term risk to the industry.

Some investors who viewed fixed income as a lower-return, lower-risk class could lose confidence in hedge funds, he said, especially if their managers had been caught out by recent events.

"Many mortgage backed securities have dropped 5% to 10%, which wipes out gains for the past six months or perhaps the past year. It is another reminder that these things are not totally insulated," Smith said.

Many investors could withdraw from hedge funds in favour of long-only investments because they believed an economic upturn is nigh, he added.

Omar Kodmani, senior executive officer at Permal Investments, said while losses many funds had suffered so far would not be enough to close fixed income funds, continued draw-downs could.

"Volatility will continue, so survival depends on how funds adjust to the volatility," he said.

"You have a number of managed futures funds that are trend following systems, which have been particularly hard hit. They were positioned fora continuing trend of bond market strength and now they have repositioned for weakness, so they could be doubly hit."

Convertible bond funds are also in a particularly worrying position, according to Peter Arkell, director at Fortune Asset Management.

"Investment banks issue convertibles and get paid a fee," he said. "They make a market in convertibles on behalf of hedge funds who are the biggest buyer. It is in their interest to inflate convertible bond prices to keep things sweet, but if everyone panics and rushes for the door they could fall."

Chris Jones from London fund of hedge fund manager IO Investors, said the recent difficulties would highlight funds with sufficient coverage of markets and risk management to withstand financial squeezes spread blow-outs may impose.

"The thing to worry about when the blow-outs happen is who will be looked upon well by their brokers, the big institutional players, because if you get margin calls you are essentially called upon to liquidate positions and losses will be compounded. The little guys are going to suffer the worst."

Jones added the volatility that hit on the last day of July and first day of August meant "sustained mark-to-market losses for many players" who had put positions on expecting widened spreads to revert.

"However, this is not necessarily a problem because the more inefficiency there is, the more funds specifically fixed income arbitrage, can get return. But the aim is to survive any incident that causes blow outs."

However, while recent bond volatility may have hurt some managers, it has also created an environment with attractive relative value opportunities, according to Yung Lim, manager of the Treesdale Fixed Income Fund.

"The recent volatility has caused various dislocations in the market, generating opportunities with good return potential during the next six to 12 months," he said.

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