Higher for longer: Security selection in a normalized interest rate environment
The challenges for hedge funds over the last decade are well known.
But with interest rates holding higher for longer, they are arguably operating on a completely different playing field, which could mean an entirely different opportunity set. In this series we pinpoint exactly where these opportunities may be and how investors can capture them.
The return of higher interest rates marks a pivotal change in the global investment landscape. By design, this type of environment seeks to cool the economic engine by directly increasing the cost of capital, tightening access to funding, limiting growth and, consequently, introducing more risk for businesses.
With sticky inflation, resilient labor markets and a shift away from the ultra-loose monetary policies of the past decade, there is a strong expectation that this elevated rate environment will last longer. Add into this mix the disruptive potential of artificial intelligence (AI), the decarbonization and electrification of energy systems, persistent inflation, and continued geopolitical challenges, and it seems likely we will continue to see pressure on business models.
That dynamic may place greater emphasis on company fundamentals as firms navigate these challenges, arguably leading to more divergent outcomes across sectors, capital structures and issuers. The resulting dispersion, typically accompanied by higher and/or more episodic volatility in both equity and credit markets, amplifies idiosyncratic drivers and may thereby facilitate the alpha potential for long/short security specialists who can select companies that will either profit or struggle.
Higher for longer: Security selection in a normalized interest rate environment
The new opportunity set
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Assessing higher interest rates and equity dispersionHigher rates are increasing pressure on company fundamentals, driving wider valuation and earnings dispersion. This could creates stronger opportunities for long/short equity managers to back resilient, cash-generative businesses and short weaker, leveraged or structurally challenged firms.
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Enhanced carry — Short rebates and unencumbered cashElevated policy rates could meaningfully boost the economics of shorting and the return on uninvested cash. What was previously a drag now may add incremental return and balance-sheet flexibility, improving the overall carry profile of long/short strategies.
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Assessing higher interest rates and credit dispersionRefinancing costs are rising and spreads are widening, particularly for lower-rated or highly leveraged issuers. Differences in maturity profiles, sectors and regions create sharp divergence in credit quality, strengthening the case for selective long/short credit positioning.
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The breadth of long/short styles in a higher-for-longer regimeA wide range of fundamental, quantitative, trading and directional long/short styles can potentially take advantage of today’s higher volatility, valuation dislocations and structural shifts. This diversity may allow managers to capture multiple forms of idiosyncratic alpha.
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Security selection matters more than everWith dispersion elevated across both equities and credit, we believe manager skill becomes a key determinant of returns. Strong security selectors are well positioned to identify outperformers and underperformers, making active long/short approaches increasingly valuable within diversified hedge fund portfolios.