Fixed-Income Arbitrage

What Is Fixed-Income Arbitrage?

Fixed-income arbitrage is an investment strategy that attempts to profit from pricing differences in various bonds or other interest-rate securities.

Understanding Fixed-Income Arbitrage

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 bond market will trend higher or lower in the future.

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.

The strategy includes taking a short position on the issue that appears to be overpriced and a long position on the security that is underpriced. The expectation is that the gap between these prices should close and even if both of them move up or down, they should move relatively closer to one another.

The two main challenges in this strategy include, first, the need for these securities to be sufficiently liquid, and second, that the fixed-income securities chosen for arbitrage are sufficiently similar in nature. Without these two conditions, traders will find it difficult to profit from a timely narrowing of the price difference.

Even simple 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 have been so 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. 

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.

Fixed-Income Arbitrage and Swap-Spread Arbitrage

Some of the strategies referred to in casual communication as fixed-income arbitrage may not actually fit the definition of a pure arbitrage trade — one that seeks to exploit a nearly riskless trade based on mere mathematical differences. For the most part, such pure arbitrage opportunities are extremely rare. A more common form of fixed-income arbitrage focuses on temporary pricing misalignments that occur naturally in any market system.

A common example of a fixed-income arbitrage strategy that does not fit the mold of pure 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 a floating rate, such as 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.