Fixed Income Arbitrage Defined



Apart from the many investment strategies define previously, Fixed Income Arbitrage is another move used by institutional traders. It is particularly popular with Hedge Funds that are interested in securities with regular flows of income. These regular cash flows offer a chance for the Hedge Fund owner to have a buffer against the immense market risk he is exposed to.

Maximizing arbitrage gains from Fixed Income Securities has become quite common. Hedge Funds have started to invest greatly in this strategy because the absolute returns of this instrument, together with a Hedge Fund Manager’s complex asset management knowledge, are a striking combination that usually always results in profit for the investor.

To fully understand Fixed Income Arbitrage, you will have to break down the term and grasp the concepts individually because each carries a meaning that contributes to the way FIA functions.

The Concept of Arbitrage

What is arbitrage and how is it practiced in financial terms? Very simply defined, arbitrage is the art of buying financial securities like bonds in one market and selling them in another. The backbone of arbitrage- the one aspect on which this buying and selling principle stands- is the presence of a price discrepancy between the two markets that a trader chooses.

In layman terms, let’s assume there is a shortage of apples in your country and a surplus in the neighboring country. Because of the obvious price difference, owing to difference in supply, you can arbitrage from this condition by buying lots of apples from the neighboring country and selling it at a high price in your market.

Now take a look at the same concept from a financial perspective. If two securities do not have a ‘price sync’ in multiple markets, they present a chance for an institutional investor to profit from the difference. For Hedge Funds, arbitrage means buying and selling two similar securities in a market almost simultaneously, i.e. before the price discrepancy vanishes.

The arbitrageur takes a short position on securities that are overpriced and a long position on securities that are under-priced. This way he benefits from trading each. An important assumption about arbitrage is that price discrepancies will eventually be settled as more and more traders start to take notice of them. Therefore, buying and selling has to be done simultaneously.

Arbitrage with Fixed Income Securities

Fixed Income Securities are tools that generate fixed, absolute incomes over time. Also known as Fixed-Interest Securities, these instruments work in a manner very similar to debts. For instance, a bank or government sells you a FIS today. For the duration of its life, the security will pay you fixed income and when it matures, the amount will be paid back in full. Some examples of Fixed Income Securities are bonds, debentures, credit swaps, capital notes and convertible notes.

Making use of differences in prices of various fixed income securities, between a bond and a credit swap or a capital note and a bond, is then called Fixed Income Arbitrage. If looked at in isolation, a single arbitrage opportunity yields a very small profit. However, Hedge Funds are credited with making large-scale Fixed Income Arbitrage investments, the combined profits of which are then sizable enough to be recognized.

Risk and Reward with Fixed Income Arbitrage

The risk-reward relationship for such investments is the same as any other in the financial market. Therefore, the reason only very sophisticated Hedge Funds get involved in serious arbitrage opportunities is that they have massive asset backups that allow them to shoulder such high risks.

Despite this fact, Hedge Funds are more than happy to own and manage Fixed Income instruments and take arbitrage opportunities related to them because when compared to Emerging Market Investments and Event Driven Investments, FIA provides a relatively safe bet because of the steady income streams generated.

As mentioned, many Fixed Income securities that can be made use of to earn arbitrage income. The presence of these securities gives Hedge Fund Managers the necessary options they need to decide which ones to invest in, depending on their own financial stability, strength of assets and the overall nature of their investment portfolio.