• Birch Grove credit hedge fund made money 24 of last 25 months.
  • Manager sees volatility continuing as defaults, rates rise.

August ruined Jonathan Berger’s perfect record.

Since Berger started trading at his Birch Grove Capital hedge fund in August 2013, he’s been saying that credit markets are dicey. That’s why his long bets on corporate bonds have mostly been matched by wagers on falling prices, a conservative stance that helped his $800 million firm make money for 24 months running -- trouncing competitors and the high-yield market.

“As we have said for the past two years, we are in a fragile market with volatility risk at a high point,” wrote Berger, 46, in his July report to clients.

The rout in August erased more than $5 trillion from global stock markets as China devalued the yuan and reports signaled growth in the world’s second-biggest economy was slowing. High-yield bonds also dropped, though much less than stocks, losing 1.8 percent including dividends. Berger’s fund lost half a percent, according to a person familiar with the firm.

While Berger’s winning streak is no longer intact, he’s still beating his competition. His fund gained about 2.5 percent this year, and about 12.8 percent over the last 25 months, according to an investor report. That return has beaten the Bank of America Merrill Lynch U.S. High-Yield Index, which earned 6.6 percent in the same period, and other credit hedge funds, which have risen 4.4 percent, according to Hedge Fund Research Inc.

More trouble is looming, Berger wrote, although he is not planning on making big bets on falling prices just yet because he expects more market swings.

Defaults Rising

In the past year, high-yield bonds issued by energy companies and metals and mining firms have all seen default rates rise. Berger expects other sectors to follow suit, he said in his July report.

For now defaults are still low. In mid-August, Fitch Ratings predicted that defaults would be about 3 percent by the end of the month. That’s still below the average junk default rate of 4.1 percent, according to Fitch.

“Rising default rates and rising interest rates will pose a major headwind for the high-yield market,” Berger said in the client note. That will reduce flows into mutual funds and exchange-traded funds, further weakening a market dominated by retail capital.

The spread between high-yield debt and Treasuries is now near historic highs, yet the difference between the yields on BB-rated bonds and the riskiest junk bonds tightened since August, suggesting that the lowest-quality bonds are still expensive.

Event Driven

While Berger isn’t betting against any individual junk bonds yet, he is short individual investment grade bonds. His wagers on falling prices include buying options on credit indexes and shorting individual companies with an investment grade rating, the report said.

About two-thirds of his portfolio is in so-called event-driven trades, such as bets on the debt of companies going through spinoffs or leveraged buyouts, mostly of mid-cap firms, the report said. He’s also been purchasing the convertible bonds of takeover candidates, while shorting the stock or buying options that gain in value if the stock price falls.

Ed Rowley, a spokesman for New York-based Birch Grove at ASC Advisors, declined to comment.

Before starting Birch Grove, Berger was the former president and chief investment officer of Stone Tower Capital, where he was responsible for overseeing $2 billion in credit hedge funds.

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