An improving U.S. economy has led the Federal Reserve to taper its purchases of Treasuries and mortgage backed securities. As this significant source of demand leaves the market, interest rates could continue to move higher, creating a headwind for duration assets.

For a preview of what this may look like for fixed income investors, we need not look far. Between May and early September 2013, fixed income (as measured by the Barclays U.S. Aggregate Index) experienced its second largest drawdown (–4.87%) since 1990 and, as a result, investors pulled $40bn from bond funds and ETFs.1 We believe a potential solution for investors looking to decrease duration risk may be to allocate to hedge funds.

While we continue to believe that core bonds are a critical element of a prudent investor's portfolio, we have seen considerable interest from clients exploring alternatives to fixed income—including hedge funds—in order to reduce interest rate risk. In this PDF, we explore the merits of this idea, by examining the impact that rising interest rates may have on core fixed income, comparing the performance of hedge funds and fixed income in rising rate scenarios, and summarizing the outlook for hedge fund investments. Finally, we describe how clients are implementing this opportunity in portfolios.


Rising interest rates may be a headwind for core fixed income

Over the last 30+ years, fixed income has experienced the longest bull market of any asset class in U.S. history. Investors in this asset class have benefited from this trend as decreasing interest rates have increased the present value of future bond cash flows. During this period, the yield on the 10-year U.S. Treasury—the benchmark rate for many fixed income investments—fell from 14% to 1.4%2 and the Barclays U.S. Aggregate Index (the "Barclays Agg"), which tracks investment grade fixed income in the U.S. (ex-munis, TIPS, and variable rate instruments), has more than quadrupled.3

Investors are considering alternatives to their fixed income allocations.

As the U.S. economy continues to improve and the potential for interest rates to rise increases, investors are considering alternatives to their fixed income allocations. An appropriate solution for investors looking to decrease duration risk may be to allocate to hedge funds. As discussed in this PDF, we believe the outlook for hedge funds is favorable relative to traditional assets. Hedge fund managers have historically been able to generate attractive returns when fixed income may be challenged: during periods of rising rates. Investors who are allocating to hedge funds from fixed income are doing so mostly via diversified hedge fund portfolios and long/short and distressed credit funds. These vehicles have historically had different drivers of risk and return and, therefore, have produced meaningful portfolio benefits when integrated with fixed income holdings. At JPMAAM HFS, we have an 18-year track record of investing in hedge funds and providing innovative solutions, including creating complementary portfolios that can reduce beta to fixed income markets.

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