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What is a Fixed Income Hedge Fund?

Jim B.
Jim B.

A fixed income hedge fund is a pooled investment vehicle for wealthy individuals that focuses on fixed income instruments like bonds. By primarily utilizing bonds, which offer investors regular interest payments as well as a return of the principal payment for the bonds, these funds are generally safe from the volatility associated with stocks. In addition, a fixed income hedge fund may use more aggressive techniques like derivatives and arbitrage for higher profit potential. These techniques also increase the risk factor of the funds, which are managed by experienced finance professionals.

Some investors may wish to increase the diversity of their portfolios by taking part in mutual funds, which pool capital from multiple investors and make investments in a wide variety of vehicles. Wealthy individuals can take part in a similar instrument known as a hedge fund. Like a mutual fund, a hedge fund is a pooled investment and is professionally managed, but it is open to only specific investors who must make a large capital commitment. A fixed income hedge fund is a fund devoted to investments that can almost assure investors growth of their capital.

Businessman with a briefcase
Businessman with a briefcase

The most common investment found in a fixed income hedge fund is a bond. When an institution issues a bond to investors, it promises to repay the principal of the bond as well as to make regular interest payments at a specified rate. Investors can generally expect these payments on a periodic basis unless the institution offering the bond defaults on its repayment obligations.

It is common for a fixed income hedge fund to split up its bond investments between safe government-issued bonds and riskier corporate bonds. Corporations that issue bonds may have to offer up higher interest rates to investors in return for the investor taking on the significant risk of default by those corporations, a risk that generally isn't a factor with government bonds. A hedge fund can combine bonds of different risk levels to balance out its portfolio.

Depending on the goals of the fixed income hedge fund, it may indulge in riskier strategies involving derivatives and arbitrage. Derivatives are contracts that base their value on the value of some underlying security without giving the buyer of the contract actual ownership of the security. Arbitrage, often used in conjunction with derivatives, is a hedging technique by which a fund can incorporate two investments seemingly at odds with each other, such as buying and selling similar amounts of a security, in an effort to benefit from interest rate discrepancies. Each of these strategies carries the potential for high profits but also incorporate increased risk levels.

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