Understanding Hedge Fund Strategies: Fixed-Income Arbitrage Strategies

manhattan3-hedgethink Understanding Hedge Fund Strategies: Fixed-Income Arbitrage Strategies

Primarily an investment strategy used by hedge funds and investment banks, the management of fixed-income securities has increased over the years, as an increasing number of traders and risk managers continue to swap their investment banks for positions as hedge fund managers.

These traders have brought specialist product, portfolio and risk management knowledge with them into the world of traditional hedge funds, making it harder for traditional managers to compete in this particular investment area. Fixed-income funds seek to bring investors absolute returns, utilizing a whole range of fixed-income and derivative products to extract relative value and maximize arbitrage opportunities.

Understanding Fixed-Income Securities

Fixed income securities are also known as fixed-interest securities, and they’re typically issued by borrowers who require additional funds for extended periods of time.

Issuers of such securities are often banks, governments or corporations. In issuing these securities they are required to make a series of specified payments to the holder of the income security over a specific period of time. Once this period ends the initial amount borrowed will be repaid to the holder of the income security in full.

Essentially this means that investors can purchase these borrowings in exchange for a regular income stream and the eventual full return of their investment.

A whole range of interest-bearing debt securities fall under the banner of fixed-income securities. These include capital notes, convertible notes, bonds, debentures and others.

Fixed-Income Securities vs. Shares

Fixed-income securities are typically used by hedge funds and other investors in order to diversify their portfolios, complementing and supplementing other investments in order to reduce overall risk. In this way, they are utilized by fund managers in a similar manner to shares.

However, that’s where the similarity ends. Whereas shares represent part ownership of a company, when you purchase fixed-income securities you are making a loan to a company, for which you will receive scheduled interest payments (called the income coupon), and finally receive the principal of the loan back.

For this reason, many investors prefer to choose fixed-income securities over shares as it allows them to rely on a steady income stream, as opposed to the unpredictability of company dividends. They are a profitable alternative for those risk-averse funds looking to avoid the price volatility associated with shares.

Fixed-Income Arbitrage

At the opposite end of the risk scale from high volatility investment strategies like event-driven and emerging markets, fixed-income arbitrage funds seek to provide investors with minimal monthly volatility as well as solid returns. In order to achieve this, fixed-income managers will seek to take both long (bought) and short (sold) positions in a range of fixed-income securities.

Arbitrage – arbitrage is term given to the simultaneous purchase and sell of a security in order to profit from a differential in the price. An arbitrageur seeks to purchase a perceived undervalued security and to go short on a perceived overvalued security. In reality, it’s very hard to carry out ‘pure’ or ‘risk-free’ arbitrage, as there is often some level of risk involved in executing any arbitrage strategy.

Types of Fixed-Income Arbitrage

Hedge fund managers have a range of fixed-income arbitrage opportunities to exploit. These include: mortgage-backed security arbitrage, government bond yield curve arbitrage, corporate bond arbitrage and convertible bond arbitrage.

Corporate bond arbitrage – Taking a closer look at corporate bond arbitrage as an example, here the fund manager looks to take advantage of any perceived mispricing in the capital structure of related securities issue by the corporate issuer. This is done by examining different areas of the capital structure of a company, including equity, senior debt and subordinated debt.

Credit derivatives – Arbitrage investors will also often use credit derivatives of the underlying issuer to express long and short views. For example, an arbitrageur might perceive that the subordinated debt of a company is trading cheap to the underlying senior debt of the same Company. The arbitrager will then invest in the subordinated debt while short selling the senior debt of the company in order to carry out the long/short strategy. A profit is made here from any narrowing in the yield differential of the two instruments. Differentials can occur in the yield of the same underlying issuer for reasons including liquidity, tax and regulatory reasons, as well as differing investor appetite.

Understanding Arbitrage Strategy Risks

As with any investment strategy, any arbitrage strategy carries with it some risk. Typically risk is highest when unwinding positions, or when setting both legs simultaneously.

In order to minimize risks, an arbitrageur needs to examine the holding or carry costs of combined positions, and the possible impact of not being able to borrow securities at an acceptable cost for the ‘short sold’ leg of the strategy. A major worry for arbitrageurs is the risk of being unable to borrow ‘short sold’ securities, which can force them out of position.

Understanding Fixed-Income Securities Risks

Whenever you invest in fixed-income securities, you’re running the risk that the market value of your investment might decrease. Additionally, there is the added risk that the issuer may not be able to keep up its regular interest payments, or that it will lack the funds to fully repay your principal loan on maturity.

The prices of fixed-income securities can change dependent on several factors, such as market interest rate levels in general, the size of the interest coupon, the credit rating of the issuer, as well as the structure of the underlying security. Should interest rates hop up, for example, the security price of a fixed-income security will generally decrease, as investors become reluctant to pay for a corporate bond when the prevailing market interest rate for a comparable bond increases.

With government bonds, when the government in question has a high credit rating, investors consider there to be virtually no risk – as government can usually be depended upon to deliver when it comes to a return of capital as well as regular interest payments. With corporoate bonds, however, the risk is increased, as a range of adverse conditions could impact the company, leading to increased uncertainty. This is why you’ll often find that companies with lower credit ratings who are issuing fixed-income securities tend to also offer investors higher yields.

It’s worth noting that should a company collapse, creditors, including fixed-income security holders, rank higher than shareholders when it comes to receiving a return on their investment.

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