While there are numerous trading and investing strategies used by seasoned investors in the financial markets, arbitrage trading strategies are typically used by large investors and institutional investors to earn profits. Arbitrage strategies employ techniques that reduce the risks associated with investments that provide investors with fairly stable returns over time. Among such strategies, fixed income arbitrage is one of the well-known methods used to maximize profits from the price differentials across asset classes.
To understand fixed income arbitrage, it is important to be well aware of fixed-income securities. A fixed income security investment refers to an asset class in which the issuer of that security pays a fixed interest payment for a specified time to the investors in that security. Government securities, bonds, treasury bills, debentures, and certificates of deposits are a few examples of fixed-income securities. These securities are generally not linked to returns from the stock market and therefore considered a low-risk investment option. Also, securities such as debentures, treasury bills, and convertible bonds can be traded in the market similar to stocks.
Now let’s get back to deciphering what is fixed income arbitrage. Under this strategy, an investor tries to capitalize the price differentials across fixed-income securities and earn profits. The investor needs to take opposite positions in the market to exploit these price differences while simultaneously limiting interest rate risk. So, an investor needs to go long on fixed-income security while simultaneously going short on the same security that capitalizes on the price discrepancies. The fixed income arbitrage method is a market-neutral strategy, i.e., the returns from this strategy are typically not dependent on the market volatility and so an investor can get a return on his investment from this strategy irrespective of the market conditions. The price differentials for fixed-income securities only remain for a short period and an investor who is employing fixed-income arbitrage must execute it within a short window. This strategy is commonly employed by investment banks and hedge funds. In this article, let us understand how fixed income arbitrage works along with some real-world examples.
How Does Fixed Income Arbitrage Work
In the world of hedge funds, fixed income arbitrage strategy refers to an act of buying and selling fixed-income securities simultaneously. The price of those securities, in the opinion of the trader, are not anywhere near the true value of those securities. The trader assumes that the prices of those securities will eventually converge to their true values. So, the trader sells short the overpriced security and buys long the underpriced security. The inherent expectation on the part of the trader is that the price differences should become smaller even though the prices may move in the same or in the opposite direction. After the prices return to their true values, the trade can be liquidated to realize a profit. Hedge funds and investment banks employ this strategy routinely for fixed-income securities such as government bonds, corporate bonds, mortgage-backed securities, and credit default swaps. The return from fixed income arbitrage is not affected whether the market value of the security trends upwards or downwards.
To employ the fixed-income arbitrage strategy, the following conditions must be satisfied -
Those fixed-income securities must be highly liquid so that an investor can buy and sell them in the market easily and conveniently
While employing the fixed income arbitrage strategy, the securities that are traded must be very similar to each other with minimum price differentials.
Once the above two conditions are satisfied, an investor needs to take a long position on a security that is underpriced and a short position on a similar security that is overpriced. When these trades are executed at once, the price differentials get locked-in and after the prices converge towards the true values, the trades can be executed to realize the gains.
Real-World Examples
Let us consider an example that will help illustrate how a fixed-income arbitrage strategy works in the real world. Suppose an investor or a hedge fund observes that the yield rate on a 15-year corporate bond is higher than the fixed interest rate on a 15-year interest rate swap contract. Given this situation, the following arbitrage strategy can be executed -
Step 1: The investor or the hedge fund can borrow funds to buy the corporate bond.
Step 2: At the same time, the investor needs to enter into an agreement for the interest rate swap so as to receive specified payments and pay variable payments.
Step 3: The interest rate risk needs to be hedged by short-selling an equivalent period of corporate bond futures.
Step 4: A higher yield can be earned from the corporate bond while receiving fixed payments by executing the contract of interest rate swap.
Step 5: Whenever the price differential comes to a minimum or reaches an expected level of profits, execute the trade and cash in the profits.
As you can see, an individual or an institutional investor can benefit from this fixed income arbitrage strategy from the short-term price differentials between the corporate bond and interest rate swap. Profits can be realized irrespective of both the prices moving in the same direction or in the opposite direction.
Consider another example of the fixed income arbitrage strategy frequently employed by investors. Suppose there is a fixed income security of a company such as a convertible bond, the deviation between the market prices of the convertible bond and the company stock can be leveraged to earn profits. Also, consider that the stock of the company is overpriced and the convertible bond is underpriced as per the investor. Now, the investor can take a long position on the bond while simultaneously taking a short position on the underlying stock. When the price of the stock reduces, the short selling approach will generate substantial profits while the long position on the bond will only see minimum correction in price. The differentials between the prices in long position and short position will be the gains from the overall trade. On the other hand, if the convertible bond priced higher compared to the underlying company stock, the opposite approach needs to be followed. The convertible bond is to be short sold while assuming a long position on the company stock. Again, the price deviations between the long and the short positions will generate profits from the trade.
Some of the popular fixed income arbitrage strategies are swap spread arbitrage, mortgage arbitrage, yield curve arbitrage, capital structure arbitrage, and volatility arbitrage.
Conclusion
While fixed income arbitrage is followed by hedge funds and investment banks, investors must make a note of the several downsides associated with the strategy. There are several risks associated with fixed income arbitrage though the strategy is generally thought to be “market-neutral.” The fixed income arbitrage strategy works on an assumption that the market prices of fixed income securities are incorrect and they will converge to their true values at some point of time in the future. However, the magnitude of this deviation between market price and true price depends on the models being used for evaluation. Bond pricing models for bonds issued by corporations and those pertaining to developing economies are not free from errors. In a way, this risk refers to the fact that the price differential between the two securities does not minimize as predicted earlier. This reduces the profit earning potential from fixed income securities. Then, there is always a possibility of market risk. If the interest rates change suddenly, then the prices of fixed income securities will get affected, resulting in huge losses for the investor.
Leverage risk also affects the returns from a fixed income arbitrage strategy. Even though investors expect to leverage the minor price differences between the securities and earn profits, there could be a case where the price movements are not according to the expectations of the investors. So, in a way, though profits are magnified, the losses can also get magnified by following this strategy. Investors who follow this strategy require huge capital to be invested. Also, an increasingly higher amount of capital gets locked up while following fixed income arbitrage strategy and those funds cannot be deployed towards other investment strategies. The opportunities to profit from fixed income arbitrage also becomes harder to spot and the magnitude of profits keeps reducing.
Therefore, fixed income arbitrage can have downsides with all the returns that can be generated out of it. You also need to have significant capital in order to follow this strategy which is precisely the reason why hedge funds and investment banks follow this arbitrage method. As an investor you should be aware of market conditions to evaluate potential income generating opportunities.
