Long-Short Credit Funds Have Potential as Bond Diversifiers

Josh Charlson: Earlier this year Morningstar launched a new long-short credit category. We did so to recognize both growth in these types of funds as well as some distinctions between them and the nontraditional bond category, from which most of these funds have been reclassified.

Long-short credit funds seek to exploit mispricings in corporate debt, which may involve outright directional long and short bets, or relative value trades focusing on different securities on a company's capital structure or pair trades between the debt of two different but correlated companies, for example.

One big difference between long-short credit funds and other nontraditional bond funds is that long-short credit managers tend to hedge out most of their interest-rate risk, putting their strategies' valuation proposition squarely on their credit selection skill.

However, long-short credit funds have struggled in recent years and face some intrinsic challenges. Unlike hedge fund versions of the strategy, mutual fund managers cannot employ the same degree of leverage or illiquid investments, which limits their return potential. In addition, their lack of interest-rate sensitivity has been a decided headwind over the past half decade.

That said, long-short credit funds do offer potential as a strong bond diversifier in the rising interest-rate environment we may experience going forward. And greater volatility and dispersion in the markets could create opportunities for these managers. It's worth noting that one of the category's largest funds, Bronze-rated Driehaus Active Income, recently reopened its doors to new investors.