What is Fixed-Income Arbitrage
Fixed-income arbitrage is an investment strategy that attempts to profit from pricing differences in interest rate securities. When using a fixed-income arbitrage strategy, the investor assumes opposing positions in the market to take advantage of small price discrepancies while limiting interest rate risk. Fixed-income arbitrage is a market-neutral strategy, meaning that it is designed to profit regardless of whether the overall market is bullish or bearish.
BREAKING DOWN Fixed-Income Arbitrage
Fixed-income arbitrage is primarily used by hedge funds and investment banks. These funds watch a range of fixed-income instruments, including mortgage-backed securities (MBS), government bonds, corporate bonds, municipal bonds and even more complex instruments like credit default swaps (CDS). When there are signs of mispricing in the same or similar issues, fixed-income arbitrage funds take leveraged long and short positions to profit when the pricing is corrected in the market.
Fixed-Income Arbitrage and Swap-Spread Arbitrage
Some of the strategies classified as fixed-income arbitrage do not meet the definition of pure arbitrage. For the most part, pure arbitrage opportunities are rare, so fixed-income arbitrage focuses on temporary pricing misalignments that occur naturally in any market system. A common fixed-income arbitrage strategy that does not fit the mold of traditional arbitrage is swap-spread arbitrage. In this trade, the investor takes up positions in an interest rate swap, a Treasury bond and a repo rate to profit on the difference between the swap spread — the spread between the fixed swap rate and the coupon rate of the Treasury par bond — and the floating spread, which is the difference between London Interbank Offered Rate (LIBOR) and the repo rate. If the two rates converge or even reverse from their historical trends, then the arbitrager takes losses that are magnified by the leverage used to create the trade.
Fixed-Income Arbitrage and Long-Term Capital Management
Even simpler fixed-income arbitrage trades carry risks. Depending on the type of fixed-income security, the chance of market pricing actually being in error depends heavily on the model being used to evaluate the instruments. Models, particularly those dealing with bonds issued by companies and developing economies, can be wrong and they have been in the past. Many investors still recall the implosion of Long-Term Capital Management (LTCM), which was a leading fund in practicing fixed-income arbitrage. This association with LTCM explains the strategy's reputation as picking up nickels in front of a steamroller: the returns are small and the risks can be crushing.
Fixed-Income Arbitrage and Institutional Investors
As the returns created from closing these pricing gaps are small, fixed-income arbitrage is a strategy for well capitalized institutional investors. The amounts of leverage involved to make the trades meaningful are not available to individual investors. Funds that employ fixed-income arbitrage generally brand it as a capital preservation strategy. In addition to the amount of capital needed to perform fixed-income arbitrage, there is another hurdle facing anyone attempting this type of investment. As more capital is dedicated to finding and profiting from fixed-income arbitrage, opportunities become harder to find, smaller in magnitude and shorter in duration. However, the market rarely maintains an optimal level of anything for long, so fixed-income arbitrage swings between periods where it is underused and highly profitable to being overused and barely profitable.