- Undervalued debt securities are also referred to as distressed debt securities, and are among the riskiest in the fixed-income market. The companies that originally issued the securities have seen their financial conditions deteriorating, and likely their debt is selling for pennies on the dollar. While most investors shy away from risky distressed corporate debt, fixed-income hedge funds see the deep discount on distressed debt securities as an opportunity for potentially higher reward. Many hedge fund managers are also expert in the business and industry that the debt issuers are in, and by helping companies launch a recovery effort, hedge funds stand to benefit from abnormal returns when prices on undervalued debt securities begin to rise.
- While most fixed-income investors look for steady income payments in fixed-income securities, especially if they hold them to maturity, fixed-income hedge funds often speculate on market interest rate moves for future price change when investing in fixed-income securities. As market interest rates increase or decrease, prices of fixed-income securities will decline or rise. To bet on a potential price increase, fixed-income hedge funds would buy fixed income securities whose interest rate might drop and sell them later for a profit. Funds would sell short if the bet is on a potential price decrease with a rise in interest rate, and buy back securities later at lower prices for a profit.
- While mutual funds serving the most general investing public are very selective when using short selling strategies, hedge funds are all-embracing, if not exclusive, in making the best use of short selling. Most hedge funds speculate on market moves in both up and down directions. For fixed-income hedge funds, they may buy certain fixed-income securities betting on credit improvement from the issuers, and meanwhile sell others betting on credit deterioration from the issuers. Both fixed-income securities of investment grade and low quality are regular plays for fixed-income hedge funds.
- Fixed-income hedge funds not only explore debt securities of different quality from different issuers but also mispriced debt of different classes by the same issuers. Company debt can be classified as senior debt and subordinate debt. Senior debt is often secured by collateral and subordinate debt is unsecured, inherently with more risk. Because of the different risk perception by investors on the two classes of debt, the riskier unsecured subordinate debt may be undervalued and priced at a discount, while the safer secured senior debt may be overvalued and priced at a premium. By purchasing the cheap subordinate debt and short selling the expensive senior debt at the same time, fixed-income hedge funds can achieve greater returns compared to using a more conservative investment strategy.
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