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Fixed-Income Artbitrage: Less Risk, More Return

By: Michael Gorman

Since its inception in the early 1980s on the proprietary-trading desk of Solomon Brothers, fixed-income arbitrage has been a controversial strategy. Many believe it to be a highly risky and opaque gamble due to its dependence on large amounts of leverage. Others, however, believe that it has a place in more investors' portfolios and has been unfairly tarnished by a few high-profile debacles. A case in point: some industry watchers blamed the strategy's decline in 2008 on its risky approach as opposed to the deleveraging of the industry.

Recently, a partner of a New York-based fixed-income arbitrage fund shared a few insights on the strategy: "Managers using this strategy employ proprietary financial models and analytics to find relative 'cheapness' and 'richness' in certain bond market sectors, to figure out why the bonds are cheap or rich, to understand the capital flows and market catalysts that will eventually rectify the supply-demand imbalances causing the cheapness or richness, and to determine how to scale into the trade to capture the opportunity. As you can imagine, the panicked movements that have taken place in Europe over the past few quarters have provided lucrative opportunities."

Because fixed-income arbitrage takes advantage of small price discrepancies in securities, it benefits from market volatility. In the past three years, general economic and political uncertainty as well as government intervention in the capital markets has increased volatility. In reaction to the global financial crisis, stakeholders with noneconomic incentives, including the Federal Reserve, the European Central Bank, and the Bank of England, intervened. This altered markets in a way that drove prices away from their efficient levels. Programs such as the Federal Reserve's Quantitative Easing and Operation Twist injected billions into the markets, depressing the price of some securities and driving others to irrational premiums.

These interventions were designed to achieve a political agenda, but in the process, they created short-term supply and demand imbalances, providing tremendous opportunities for savvy traders to step in and profit as market forces acted to bring prices back to their efficient levels. According to the Barclay Fixed Income Arbitrage Index, the strategy has been up three years in a row: 19.83% in 2009, 11.65% in 2010, and 4.48% in 2011.

In an environment where strong risk-adjusted returns have been difficult to come by, some investors have considered relative value strategies, such as fixed-income arbitrage, as a means of adding a consistent source of return to their portfolios. Investor interest was heightened on July 21, 2010, when the U.S. government signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, which includes the now notorious Volcker Rule. This provision prevents proprietary trading desks at large investment banks from making speculative trades. This new regulatory regime lifted an immense weight from the shoulders of many fixed-income-arbitrage fund managers. Prior to the reform, the trading desks of large banks had dominated the market, trading with such frequency and volume that in order for smaller funds to compete, they had to assume large amounts of leverage; the bond price spreads were often so slim and the return to equilibrium so quick that funds had to take large positions in order to profit.

Banning banks from speculative trading is a boon to the managers who survived the dramatic deleveraging of the past several years. They can now enjoy wider price dislocations and for longer periods, thereby achieving similar results as before but with less leverage (that is to say, less risk).

Of the nearly two thousand investors BHA analysts have interviewed over the past six months, including funds of funds, family offices, endowments, pensions, and wealth advisors from all over the world, less than 6% expressed an interest in or need for fixed-income arbitrage. However, as market volatility continues, and as investors become increasingly aware of the implications of the Volker Rule, BHA expects that fixed-income arbitrage will garner more attention.