Fixed Income Arbitrage Strategies and Hedge Funds

Fixed Income Arbitrage Investment Strategy

By Richard Wilson – 
Fixed income arbitrage strategies exploit pricing differentials between fixed income securities. Some of the most famous fixed income arbitrageurs were the principals of Long Term Capital Management, the hedge fund that returned annualized returns of over 40% in its first years. However, in 1998, when some of its bets moved against it, the fund had to be rescued by prominent Wall Street firms with a $3.5 billion package orchestrated by the Fed.

Some of the most widely used fixed income arbitrage strategies are swap-spread arbitrage, yield curve arbitrage, volatility arbitrage and capital structure arbitrage, all of which try to exploit perceived mispricing among one or more fixed income instruments.

Swap-spread arbitrage is a bet on the direction of swap rates, Libor, treasury coupon rates and repo rates. A typical swap-spread arb trade would consist of a fixed receiver swap and a short position in a par Treasury bond of the same maturity. The proceeds of the sale of the Treasury bond would be invested in a margin account earning the repo rate. This trade is a simple bet that the difference between the swap rate and coupon rate will be more than the difference between Libor and the repo rate. The trade could of course, be engineered in the opposite direction.

Yield curve arbitrage strategies are designed to profit from shifts in the steepness of or kinks in the US Treasury yield curve by taking long and short positions on various maturities. This could take the form of a butterfly trade, where, for example the investor goes long five-year bonds and shorts two and ten-year bonds. Or, it may take the form of a spread trade, where, the investor goes short the front end of the curve and long the back end of the curve. The strategy requires the investor to identify some points along the yield curve that are “rich” or “cheap.”

In their simplest form volatility arbitrage strategies profit from the well-known tendency of implied volatilities to exceed subsequent realized volatilities. This is done by selling options of fixed income instruments and then delta-hedging the exposure to the underlying asset. However, many hedge funds implement vastly more complex volatility arbitrage strategies, some of which are described in our bibliography.

Capital structure arbitrage strategies exploit the lack of co-ordination between various claims on a company, like its debt and stock, for example. The strategy involves buying one instrument of a company’s capital structure and hedging that exposure by selling another. For example, a trader, who believes that the debt of a company is overpriced relative to its equity, would short the company’s debt and buy its stock. Capital structure arbitrage trades may also trade junior vs. senior debt or even convertible bonds vs. stock.

Lhabitant, Francoise-Serge. Handbook of Hedge Funds. West Sussex: John Wiley & Sons, Ltd., 2006.This is an excellent guide to the industry, with concise and informative descriptions on all of the major hedge fund strategies and primary methods to measure their risk and performance. Lhabitant also includes an overview of the legal environment of hedge funds and their organizational structure as well as a short guide to investing in them.

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