Hedge funds use many fixed income strategies.
Hedge funds have found a variety of profitable fixed-income strategies in recent years. Fixed income is a natural fit for hedge funds, since it allows for precise mathematical calibration and an almost unlimited amount of leverage. Hedge funds can find safe, profitable fixed income strategies, and exploit these strategies to the fullest, without taking any extraordinary action.
Fixed Income
A fixed income asset is any asset which pays out a specific sum of money. The most common fixed income assets are loans and bonds, but others can include commercial paper, preferred shares and zero-coupon products. "Stub" securities created by hedging the non-fixed part of a fixed income product may also fall under the rubric of fixed income. In each case, the distinguishing factor in fixed income investing is that there is limited upside, and that there are many different fixed income products that could represent the same cash flows. This leads to a number of fixed income investing opportunities for hedge funds.
Capital Structure Arbitrage
Capital structure arbitrage refers to trades that take advantage of discrepancies in the prices of a single company's debts. For example, a company might have two bond issues, one of which is priced as if the company is safe, and another that is priced as if it is likely to go out of business. If an investor buys the latter and sells the former short, it's possible to profit from the convergence: if the company does well, the bonds that were priced for bankruptcy will go up; if it does badly, the bonds priced for success will go down.
Convertible Arbitrage
A similar kind of arbitrage appears when a company has convertible bonds or preferred stock. These are assets that can be converted into common stock at a fixed price. By buying the convertible bond and selling the stock short (or using options), the fund can create a new fixed income product with no equity exposure to the company. They can then use this product to engage in arbitrage, or simply hold it until maturity.
Distressed Debt
Many hedge funds profit from positions in distressed debt. They purchase cheap bonds from companies in dire financial straits, and either hold them passively or actively seek to maximize the value of their assets. These strategies typically require the fund to perform in-depth research into the business it is investing in, and to create a coherent plan of action. However, a hedge fund is often more focused than a bank (since it can try to earn upside, not just to avoid downside) and will have more expertise than the typical outside investor.