Hedge Fund Strategies (6) – Fixed Income Arbitrage and Spread Trades

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A high-priced spread

Fixed Income Arbitrage (FIA) is the name given to a family of trading strategies that, to various extents, use spread trades on debt instruments to take advantage of pricing inefficiencies independent of overall market direction.  A spread trade is the simultaneous purchase and shorting of related securities (and their derivatives) in the hope of profiting from the widening or narrowing of the spread (i.e. the prices) between the two securities. FIA typically deal with large quantities of highly liquid debt instruments, such as government and corporate bonds, asset-backed securities, and debt-related derivatives like swaps, futures, and options.  Positions are usually leveraged from 5 to 15 times the asset base’s value, although there is no hard and fast rule concerning this.

Because FIA spreads contain long and short legs, they tend to cancel out systematic market risks, such as changes to the yield curve. Managers are free to hedge away specific risk exposures, including risks due to changes in interest rates, creditworthiness, foreign exchange risks, and default, though the extent of hedging employed varies greatly among hedge fund managers.  Managers are also free to take directional positions instead of relying solely on pure neutral hedges.

Spreads available to FIA traders are typically small, which is why leverage is widely employed.  Leverage is gained through the use of borrowing, repurchase agreements (repos), and derivatives.  It is not unusual to put on an FIA trade for a $100 million notional amount requiring less than $1 million of posted collateral. Usually, the more basic types of FIA trades use higher levels of leverage than do more complicated trades (such as mortgage-backed security trades) that expose positions to particular risks.

FIA returns are made up of spread profits, due to systematic risk premia and/or price inefficiencies, and carry, which is the excess of positive cash flow over negative cash flow. A simple example of carry would be a long position that earned 5.25% interest paired to a short position paying out 5.05%; a 20 basis point carry profit can be achieved by this spread.

Returns from FIA trades can result from sudden market dislocations, demand or supply shocks, changes in investor preferences, restrictions on particular instruments or markets, credit rating changes, execution of options embedded within debt securities, and any event that changes a bond’s anticipated cash flow. Price inefficiencies can arise from a number of factors:

1)     Agency bias: the tendency of fiduciaries to purchase securities based on past results

2)     Structural impediments: the trading of securities for non-economic reasons relating to tax, regulatory,  and accounting issues

3)     Market segmentation:  the preference for a particular range of maturities can become pronounced enough to cause price dislocations between different securities

Systematic risk premia can result from several causes.  For instance, a hedged spread may feature long and short positions that differ in liquidity or credit quality. In this case, a premium is earned by holding lower quality or less liquid positions and shorting higher quality/more liquid positions.   Other systematic risks can arise from, among others, cross-currency trades, and spreads between Treasury and agency debt.

In general, FIA traders earn their premia by taking positions that profit when “the sky doesn’t fall”.  This is similar to selling a disaster put – the buyer would profit only in the case of catastrophe, in which case the buyer can put securities to the seller at a pre-catastrophe price.  This is a form of insurance; you might recall credit default swaps, which served a similar purpose. Normally, it works, and the put seller pockets the put’s premium when it expires without intervening economic disaster.

FIA trades behave much like the short put strategy. When turmoil occurs, there is a flight to quality that causes bond spreads to widen and liquidity to dry up, all of which cause FIA traders to realize losses. Recall that FIA traders want spreads to narrow. This “short volatility” position backfired big-time in 2007-8 during the real-estate crises. The crisis demonstrated the concept of “fat tails”: an event can be so unlikely that its occurrence is predicted only at several standard deviations from the mean, but in fact occurs more often than a normal distribution curve would imply. As a crisis unfolds, market participants all exit at the same time, and leveraged positions collapse.  Bankruptcy and financial ruin can easily follow. The collapse of Long Term Capital Management in 1999 is a famous object lesson in this regard.

Now that we have a broad overview of FIA, we’ll begin to delve into particular strategies.  Next time: yield-curve arbitrage.

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Copyright 2011 Eric Bank, Freelance Writer

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