Fixed Income Arbitrage is most famous for going bankrupt. There is no shortage of examples, starting with Long-Term Capital Management in 1998-1999. The strategy is full of concepts that investors love to hate, such as leverage and adding to trades that lose money initially. However, 2012 has been a particularly good year for this type of relative value strategy.
In 2008, in the wake of the global financial crisis, many of the large fixed income relative value shops either went out of business (Endeavour Capital, Ross Perot’s Park Central, JWM) or shrank dramatically (Myron Scholes’ Platinum Grove, London Diversified). Since then, Dodd-Frank and the Volcker rule have also reduced the competition from bank proprietary desks. Considering the 2008 crisis, increased government regulation and the despised concepts of leverage and adding to losing trades, Fixed Income Arbitrage is a marketing disaster. As a result, the space is sparsely populated.
During this same post-crisis period, governments have increased their market interventions. Recently, the Europeans injected â‚¬1 trillion via the Long Term Refinancing Operation (LTRO) and another â‚¬200 billion via the Securities Market Program (SMP). The U.K. and the U.S. have also been active in their own versions of quantitative easing. These market interventions have produced a bevy of opportunities in the fixed income space.
As with any business, reduced competition and increased opportunities make for an appealing situation. Our Fixed Income Arbitrage fund, The Barnegat Fund, was able to survive 2008 and has outperformed for the last twelve years. Barnegat has a compound annual rate of return of 18%/year since our launch in 2001. Our share price has gone from 1.00 to nearly 8.00 during that time.
Founded after the collapse of Long-Term Capital in a time of incredible opportunitiesâ€”but impossible fundraisingâ€”Barnegat began only with an investment from myself in 1999. The first two years were very difficult times. I had put all my money in the fund and was enjoying solid returns, but did not earn any fees since no one else had invested at that point. I was living in the walk-in closet of a friend in Manhattan. I had driven my expenses to $0 so that I wouldn’t get stopped out of my own trade. I was using the New York Public Library Bloomberg terminal and writing down the quotes each day to bring home and enter into the computer.
The stigma of Long-Term Capital continued to hang over Fixed Income Arbitrage for a long time after 1998. Fundraising was very difficult, but opportunities were plentiful due to the reduced competition. After two years in the marketing wilderness, Barnegat finally found an initial trio of institutional investors and began an offshore hedge fund in Bermuda with $25 million. Returns continued to be strong, up 13.5% in 2001 and up 55.9% in 2002. The fund’s Assets under Management (AUM) quickly grew. By 2003, AUM was up to $500 million at which point we closed the fund to new investments.
Hedge funds and the world’s economy really started to accelerate from 2005 through 2007. In the past, we had great opportunities, but no one would touch Fixed Income Arbitrage. However during these three years, everyone was calling, had seen our strong returns, and wanted to invest in the fund. But we didn’t have the opportunities to invest in. The markets had become too efficient. We returned capital three separate times between 2005 and 2007. Prospective investors would call and occasionally be irate when told that no new investments were accepted and that current capital was actually being returned. I told them at some point the world would become inefficient again and I would call them. Little did I know how quickly that time would come.
On Sept. 15, 2008, Lehman Brothers went bankrupt and the world entered the global financial crisis. We re-opened the fund and were back to having fantastic opportunities, but brutal fundraising. I called some of the people that were irate at our refusal to accept their investment in 2007, but they were now too scared to invest in 2008. I contacted current investors and told them that we had fantastic opportunities again. This was a very difficult time for them. Our fund was down 37% in 2008. Nevertheless, our investors stuck with us and we had net investments in 2008, something of which I am quite proud.
Those new investments have worked great for both us and the investors. We were up 132% in 2009, 16% in 2010, 11% in 2011 and nearly 40% so far this year. However, it is still very difficult to market. The market remains fearful and the Fixed Income Arbitrage collapses of 2008 are still fresh in investors’ minds.
There is no shortage of bad things to say about Fixed Income Arbitrage, but with this fear and hatred of a particular market comes reduced competition and plenty of opportunities. For investors in for the long-haul, this much maligned corner of the Fixed Income market has The Barnegat Fund, which has outperformed all major investment indexes since 2001.