Credit Hedge Funds Explained: Long/Short Credit, Relative Value and Fixed Income Strategies
A credit hedge fund invests in corporate bonds, loans, credit derivatives and other debt instruments, taking long and short positions to profit from changes in credit quality, credit spreads and pricing differences between related securities. Unlike a traditional bond fund, it can bet against weak borrowers as well as on strong ones, and it aims to generate returns that depend less on the general direction of interest rates. This guide explains the main credit and fixed income hedge fund strategies — long/short credit, distressed debt, capital structure and convertible arbitrage, and fixed income relative value — and the risks that come with them.
What Is a Credit Hedge Fund?
A credit hedge fund is a hedge fund whose main investments are debt rather than shares. Its managers analyse the ability of companies, governments or securitised pools to repay what they owe, and position the portfolio accordingly: buying debt they consider undervalued and selling short, or buying protection on, debt they consider overvalued.
Returns typically come from three sources: the income from long positions, changes in credit spreads (the extra yield investors demand over a risk-free rate), and the convergence of prices between related instruments. How credit strategies fit into the wider hedge fund landscape is explained in our overview of what hedge funds are and how they work.
Credit Hedge Funds vs Traditional Bond Funds
- Direction — a bond fund is long only; a credit hedge fund can be long and short, and can profit when a borrower's credit quality deteriorates.
- Benchmark — a bond fund is usually measured against a bond index; a credit hedge fund typically targets absolute returns.
- Instruments — credit hedge funds also use credit default swaps (CDS), loans, structured credit and derivatives to express views and hedge risks.
- Interest rate risk — many credit hedge funds hedge part of their interest rate exposure to focus on credit risk alone.
- Leverage and liquidity — hedge funds may use leverage and often have less frequent redemption terms than daily-dealing bond funds.
Main Credit and Fixed Income Hedge Fund Strategies
Long/short credit
Long/short credit applies the logic of long/short equity to corporate debt. Managers buy bonds or loans of issuers whose credit quality they expect to hold up or improve, and sell short or buy CDS protection on issuers they expect to weaken. A well-constructed long/short credit book can earn money in both tightening and widening credit markets, provided the security selection is right.
Distressed debt
Distressed debt managers buy the bonds or loans of companies in financial difficulty, often at deep discounts, expecting a recovery, a successful restructuring or a better outcome in bankruptcy than the market price implies. Returns depend on legal and restructuring expertise as much as on financial analysis, and positions can take years to play out.
Capital structure arbitrage
Capital structure arbitrage exploits pricing inconsistencies between different securities of the same issuer — for example its senior bonds, subordinated bonds, CDS and shares. If the equity and the debt imply different views of the company's risk, the manager buys the cheaper instrument and sells the more expensive one.
Convertible arbitrage
Convertible arbitrage typically buys convertible bonds and sells short the issuer's shares to hedge the equity component, aiming to profit from mispricing of the bond's embedded option, its income and changes in volatility.
Fixed income relative value
Fixed income relative value strategies look for pricing differences between closely related instruments — such as government bonds of different maturities, bonds and futures, or securities with similar cash flows — and bet on their convergence. Because the price gaps are often small, these strategies frequently use significant leverage.
What Are the Risks of Credit Hedge Funds?
Credit strategies have a characteristic risk profile: steady returns for long periods, interrupted by occasional sharp losses. The main risks are:
- Default and recovery risk — borrowers can fail, and recoveries in bankruptcy can be lower than expected.
- Spread risk — in a crisis, credit spreads can widen across the market at the same time, hitting long positions regardless of individual quality.
- Liquidity risk — many bonds and loans trade infrequently; in stressed markets it can be difficult to sell without large price concessions.
- Leverage risk — leverage magnifies small price moves and can force selling at the worst moment.
- Correlation breakdown — relationships between related instruments can diverge instead of converge.
The best-known example of how leverage and relative value combine is Long-Term Capital Management. According to the Federal Reserve History essay on LTCM, the fund ran about $30 of debt for every $1 of capital by the end of 1997, lost 44 percent of its value in August 1998 after Russia's default, and was recapitalised on 23 September 1998 when fourteen banks and brokerage firms invested $3.625 billion. Because losses in credit tend to cluster in the tails, measures such as those discussed in skewness and kurtosis in hedge fund returns are essential when comparing credit managers.
What Role Can Credit Strategies Play in a Portfolio?
Credit hedge funds are typically used to add a return stream that sits between equities and traditional bonds: more income-driven than equity strategies, but with the flexibility to profit from deteriorating credit and to hedge interest rate risk. Combined with equity, macro and event-driven strategies, they can help diversify the sources of return — the logic behind absolute return strategies and multi-strategy hedge funds.
How to Evaluate a Credit Hedge Fund
When assessing a credit manager, investors typically ask:
- Which part of the credit market does the fund focus on — investment grade, high yield, loans, distressed or structured credit?
- How much leverage is used, and how is it financed?
- How liquid are the holdings compared with the fund's redemption terms?
- How is interest rate risk managed, and how much of the return comes from spread versus duration?
- How did the fund behave in periods of credit stress, and how large were its drawdowns?
The broader due diligence process is described in our guide to hedge fund manager selection, and practical questions of access in how to invest in hedge funds.
AQUIS Capital, a Zurich-based asset management boutique licensed by the Swiss Financial Market Supervisory Authority (FINMA), includes long/short credit as one of the strategies in the AltAlpha SICAV – Abacorum Fund, a fund of hedge funds that allocates across long/short equity, long/short credit, global macro and event-driven strategies.
Frequently Asked Questions About Credit Hedge Funds
What is a credit hedge fund?
A credit hedge fund invests mainly in debt instruments such as corporate bonds, loans and credit default swaps, taking long and short positions to profit from changes in credit quality, credit spreads and pricing differences between related securities.
What is long/short credit?
Long/short credit is a strategy that buys the debt of issuers expected to remain strong or improve and sells short, or buys protection on, the debt of issuers expected to weaken. It aims to profit from credit selection rather than from the overall direction of the bond market.
What is a relative value hedge fund?
A relative value hedge fund seeks to profit from pricing differences between closely related securities, such as bonds of different maturities or different instruments of the same issuer, by buying the cheaper one and selling the more expensive one.
How do fixed income hedge funds differ from bond funds?
Bond funds are usually long-only and measured against a bond index. Fixed income hedge funds can go long and short, use derivatives and leverage, hedge interest rate risk and generally target absolute returns.
Are credit hedge funds risky?
Credit hedge funds can deliver steady returns for long periods but are exposed to default, spread, liquidity and leverage risks. Losses tend to be infrequent but sharp, especially during credit crises when spreads widen across the market.
Read more about AQUIS Capital and the team behind it, explore the AQUIS Capital fund range, or contact the team with your questions.
This content is for general information only and is not financial, investment, tax or legal advice. Investments carry risk, including the possible loss of capital. Past performance is not a reliable indicator of future results. Consult a licensed professional before making decisions.
