The bad news for credit hedge funds is they're lagging behind abroad index of bonds this year. The good news is that investorsdon't seem to care.

While relative-value credit hedge funds barely eked out apositive return in the three months through September, they're ontrack to receive the most new money since 2007 after amassing$40.57 billion in the first three quarters, Hedge Fund ResearchInc. data show. Assets in the funds, which can go short as well aslong, have about doubled in the past six years, reaching $756billion as of September.

The reason for their appeal? Pensions, insurers,and other big investors are getting nervous about lofty assetprices as the Federal Reserve prepares to raise interest rates.They want money managers who have the flexibility to profit in afalling market and are piling more cash into funds managed by firmssuch as CQS U.K. LLP, Pine River Capital Management LP, andTricadia Capital Management LLC.

“We've seen our investors want to pull funds fromtraditional fixed-income strategies and look at alternative creditstrategies,” Michael Barnes, co-founder of New York-based Tricadia,said in a telephone interview. In a world awash with central-bankstimulus, “you have to look for alpha in other places than liquidmarkets.”

The credit-focused hedge fund manager's US$2.8billion Tricadia Credit Strategies fund has returned 2.53 percentthis year through Oct. 15, and posted an average 7.5 percent annualgain in the three years ended 2013.

Tricadia, which oversees $4 billion, separatelystarted a short-biased strategy a few months ago that focuses ontrading indexes of credit derivatives. It aims to provide somepositive return in stable markets and a bigger payoff in a marketrout, Barnes said.

“Each point of positive performance that peoplesee in the fixed-income space becomes a liability with how low therate is,” said Kenneth Heinz, president of Chicago-based researchfirm HFR. Investors “are seeing the benefit of strategies that cango long and short.”

With yields on corporate debt hovering nearrecord lows, it's becoming more attractive to bet on a marketdisruption than to just own a batch of frequently-traded bonds,Barnes said.

Low Yields

Yields on corporate bonds around the world havefallen to 3.36 percent from 3.67 percent at year-end, according toa Bank of America Merrill Lynch index that includesinvestment-grade and junk-rated debt. Yields have averaged 4.94percent during the past decade.

Investor interest in hedge funds hasn'ttranslated into bigger returns this year. The Bank of AmericaMerrill Lynch Global Broad Market index gained 1.13 percent in thethree months ended Sept. 30, compared with an average 0.13 percentgain earned by credit-focused relative-value hedge funds, HFR datashow.

The BofA bond index returned 5.4 percent in thethe first nine months of the year, versus a 4.94 percent gain forthe hedge funds.

The performance has done little to curb demandfor the product. The hedge funds received $11.08 billion in thethree months ended Sept. 30 following $29.5 billion of inflows inthe first six months of the year, HFR data show. In fairness, muchof that money flowed toward hedge-fund managers who've had a goodtrack record over the past few years.

Growing Funds

CQS, the debt-focused hedge-fund firm started by Michael Hintze,has received a net $3 billion of new money this year, according toa person with direct knowledge of the matter. Its creditmulti-strategy fund started in February 2013 has amassed $2.3billion since then, said the person, who asked not to be identifiedbecause the information isn't public.

Its $3.2 billion CQS Directional Opportunities Feeder Fund Ltd.has returned 3 percent this year and 20 percent annualized sinceits 2005 inception.

Michael Rummel, a spokesman for CQS, declined tocomment.

Pine River, based in Minnetonka, Minnesota,increased its assets under management to $15.6 billion as ofSeptember from $13.9 billion at the beginning of the year,according to an investor memo obtained by Bloomberg News. PineRiver Master Fund has grown by about $1 billion in the period, to$4.5 billion.

The fund said in June it would close the fund tonew investors. It has returned 4.1 percent in 2014 throughSeptember, compared with 9.6 percent last year.

Patrick Clifford, a spokesman for Pine River atAbernathy MacGregor Group, declined to comment.

Yields on 10-year Treasuries have dropped to 2.35percent from 3 percent in December 2013, defying analystpredictions for the opposite to happen as the Fed ended its monthlybond-buying program.

When the market does start going the other way,debt investors are counting on this $756 billion bet to protectthem.

Copyright 2018 Bloomberg. All rightsreserved. This material may not be published, broadcast, rewritten,or redistributed.