Hedge funds: a safe haven amid interest rate uncertainty

As the spectre of inflation continues to loom on the economic horizon, investors find themselves navigating a challenging landscape. Policies proposed by President Trump –ranging from higher tariffs and tax cuts to stricter immigration controls – could rachet up inflationary pressures if enacted. This backdrop is obscuring the Federal Reserve's path forward, leaving open the possibility of a pause in rate cuts early in the year, a single reduction, or none at all in 2025. Amid this uncertainty surrounding rates, where can investors seek refuge while interest rates stabilise, likely later in the year?

A shifting market regime

For fixed-income investors, this new market regime poses significant challenges. Risks of stubborn inflation and mixed regional growth are likely to curb capital gains, while tight spreads offer limited protection against climbing yields. At current levels, these compressed spreads leave investors exposed to sharp yield movements, making the short-term outlook for fixed income particularly precarious.

Q4 2024 underscored these challenges. US Treasuries and investment-grade (IG) debt have been significantly impacted by the rise of bonds yields, though they managed to stay in positive territory for the year, with returns of 0.6% and 1.1%, respectively. The high-yield market held up, as spread tightening driven by strong economic data offset the rise in yields.

Amid such uncertainty, hedge fund strategies emerge as a viable safe haven. They offer investors a way to weather interest rate volatility until interest rate risks begin to stabilise later in the year. While the immediate outlook calls for caution, our long-term perspective on fixed income remains optimistic once a repricing leads to more attractive entry points for carry both in rates and credit.

Building resilient portfolios with alternatives strategies

In the face of interest rate uncertainty, credit-oriented hedge funds stand out as a compelling alternative to fixed-income investments. These strategies replicate the risk-return profile of bonds while remaining relatively independent of interest rate and credit spread volatility. Their appeal lies in the ability to deliver consistent returns with low correlation to equity markets, making them an attractive component of diversified portfolios.

Hedge funds achieve this by exploiting pricing inefficiencies and responding to market shifts. Leveraging the heightened dispersion and volatility across fixed-income markets – be it in cash instruments or derivatives – they can deliver attractive risk-adjusted returns. Even if credit default rates remain relatively contained, the current environment of spread widening and elevated market dispersion offers fertile ground for active investment strategies.

As government bond yield curves steepen, relative value and arbitrage strategies are gaining traction. These approaches thrive on capturing subtle mispricings between similar liquid instruments. The greater the volatility within the asset class, the more pronounced these pricing inefficiencies become, expanding the range of arbitrage opportunities.

Similarly, convertible bond arbitrage stands out by combining income generation with potential capital gains and could deliver above-average returns due to relatively strong issuance levels. If short-term interest rates remain in the 3–4% range, financing via a convertible rather than a conventional high-yield (HY) bond remains an attractive option.

Meanwhile, credit long/short strategies are well-positioned to capitalise on today’s dynamic fixed-income landscape. These funds take advantage of volatility and increased dispersion across individual credits. The wider the divergence between high- and low-quality credit names, the greater the potential for returns. Typically, these strategies involve taking long positions in companies well-positioned to withstand the challenges of a high-interest-rate environment, while shorting those less resilient to such pressures.