Relative Value Strategies: Fixed-Income Arbitrage

Fixed-income arbitrage strategies aim to capitalize on pricing inefficiencies by simultaneously taking long and short positions in various debt securities, such as government and corporate bonds, bank loans, and consumer debt (including credit card loans, student loans, and mortgage-backed securities). These arbitrage opportunities arise due to differences in factors like duration, credit quality, liquidity, and optionality among fixed-income instruments.

Investment Characteristics

In its most basic form, fixed-income arbitrage involves purchasing undervalued and short-selling overvalued securities, expecting the pricing discrepancies to correct themselves within the defined investment horizon. These disparities can be attributed to factors such as differences in credit quality (investment-grade vs. non-investment-grade securities), liquidity (on-the-run vs. off-the-run securities), volatility expectations (especially for securities with embedded options), and issue sizes. In a broader sense, fixed-income arbitrage can be described as the exploitation of price differences concerning expected future price relationships, with mean reversion being a significant aspect. Often, achieving a net positive relative carry over time is also a goal, which may involve capitalizing on yield curve anomalies or anticipated shifts in the yield curve's shape.

When relative credit risks across various security issuers are accepted as part of the positioning, fixed-income arbitrage evolves into what's commonly known as long/short (L/S) credit trading. This form of trading is generally more volatile than focusing solely on slight pricing differences within sovereign debt.

Fixed-income arbitrageurs often employ duration-neutral positions to mitigate interest rate risk, particularly in strategies involving both long and short positions. However, duration neutrality protects against minor shifts in the yield curve. To guard against substantial yield fluctuations and non-parallel yield curve movements (such as steepening or flattening), managers may use a range of fixed-income derivatives, including futures, forwards, swaps, and swaptions (options on swaps). Fixed-income securities also vary in complexity, with factors like sovereign risk, currency risk, credit risk, and prepayment risk affecting different types. Derivatives are useful for hedging these risks.

While fixed-income security pricing inefficiencies are often minimal, especially in highly developed capital markets, there is usually a strong correlation between various securities. Therefore, substantial leverage may be necessary and acceptable to exploit these inefficiencies. Typical leverage ratios for fixed-income arbitrage strategies range from 4 to 5 times (equity assets). In some market-neutral multi-strategy funds where fixed-income arbitrage is just one risk component, leverage levels can be as high as 12 to 15 times assets to equity. However, it's important to note that leverage amplifies the risks associated with fixed-income strategies, especially during challenging market conditions.

Another factor that adds to the complexity and risk of fixed-income arbitrage strategies is the creation of structured products around specific fixed-income cash flows, predominantly residential mortgages. These products, including tranches, aim to isolate specific credit and prepayment risk aspects. Still, they introduce additional complexity and potential volatility into relative value strategies, particularly during market stress.

Fixed-income markets are substantially larger in terms of total issuance size and scale compared to equity markets on a global scale, and they encompass a wide variety of security types. While highly liquid government securities and debt backed by sovereign entities are readily tradable in developed markets, many fixed-income securities, particularly those considered off-the-run, face challenges in terms of liquidity, making them less easily traded.

The limited liquidity of these off-the-run fixed-income securities can present opportunities for hedge fund managers to engage in strategies like relative value arbitrage. However, this opportunity also comes with inherent challenges, including the need to manage positions and liquidity risks. The opaque pricing of securities that trade infrequently can require unique strategies to navigate effectively.

Risk Profile and Liquidity

• The risk and return characteristics of fixed-income arbitrage trading stem from the notable correlations observed among various securities, the potential yield spread gains, and the wide variety of debt securities in different markets, each with distinct credit quality and pricing aspects, including convexity. The introduction of structured products around debt securities adds an extra layer of complexity that can lead to opportunities arising from pricing inefficiencies.
• In U.S. government securities, yield curve and carry trades are highly liquid but typically offer fewer opportunities for pricing discrepancies. Liquidity tends to decrease in other sovereign markets, mortgage-related markets, and particularly across corporate debt markets.
• The attractiveness of fixed-income arbitrage strategies depends on the correlations among different securities, and the yield spreads available, and the sheer number and wide diversity of debt securities across various markets.

Leverage Usage

• Elevated: This strategy frequently employs substantial leverage, though the degree of leverage tends to decrease as the complexity of the products involved increases. Hedge funds seeking to attain the desired level of leverage often use collateralized repurchase agreements facilitated by prime brokers, and these agreements come with associated leverage “haircuts” that vary based on the types of securities involved. The haircut represents the prime broker's precaution against market volatility and potential difficulties selling posted collateral during market turbulence.

Benchmarking

This is a comprehensive category that includes the following sub-indexes: HFRX and HFRI Fixed Income Relative Value Indices, Lipper TASS Fixed Income Arbitrage Index, CISDM Debt Arbitrage Index, and Credit Suisse Fixed Income Arbitrage Index.

Strategy Implementation

The most common fixed-income arbitrage strategies include yield curve trades and carry trades. Yield curve trades typically involve long and short positions at different points on the yield curve, driven by relative mispricing opportunities resulting from perceptions and forecasts of macroeconomic conditions. These positions can be in securities of the same issuer, where interest rate risk is the primary concern, or in securities of different issuers operating in the same industry or sector, where differences in credit quality, liquidity, volatility, and issue-specific characteristics drive the relative mispricing. The goal is to profit as the mispricing reverts to normal within a targeted time frame.

On the other hand, Carry trades entail going long higher-yielding security and shorting lower-yielding security to capture the positive carry and profit when the temporary relative mispricing reverts to normal. A classic example involves buying lower liquidity, off-the-run government securities and selling higher liquidity, duration-matched, on-the-run government securities. The critical concern in this strategy is liquidity risk.

The payoff profile of these fixed-income arbitrage strategies resembles that of a short put option. If the strategy unfolds as expected, it generates a positive carry and profit from spread narrowing. However, if the spread unexpectedly widens, the payoff becomes negative. Given the generally small mispricing of government securities, substantial leverage is often used to amplify potential profits. Yet, this high leverage can lead to significant losses if a temporary negative price shock triggers margin calls. This risk was evident in the case of Long-Term Capital Management's collapse following the Asian Financial Crisis in 1997 and the Russian Ruble Crisis in 1998. It's important to note that there are more complex relative value fixed-income strategies beyond the primary yield curve and carry trades.

Relative Value Strategies: Convertible Bond Arbitrage

Convertible bonds are hybrid securities that combine features of straight debt and a long equity call option. They have a conversion ratio, which determines how many shares the bond can be exchanged for, and a conversion value, calculated by multiplying the current stock price by the conversion ratio.

The conversion price is the convertible bond's current price divided by the conversion ratio. If the conversion value is considerably lower than the convertible bond's price (or if the current share price is notably below the conversion price), the call option is out-of-the-money, and the convertible bond functions more like regular debt. Conversely, if the conversion value is significantly higher than the bond's price (or if the current share price is well above the conversion price), the call option is in-the-money, and the convertible bond behaves more like the underlying equity.

Investment Characteristics

Convertible securities are inherently complex and often poorly understood due to various influencing factors. These factors include interest rates, corporate credit spreads, bond cash flows, and the value of the embedded stock option, which, in turn, is affected by dividends, stock price movements, and equity volatility. Convertible bonds are typically issued sporadically and in smaller quantities than regular debt, resulting in relatively thin trading markets. Furthermore, most convertibles lack credit ratings and have fewer covenants than straight bonds. Given the low liquidity and complexity, the options embedded within convertibles tend to trade at relatively low implied volatility levels compared to the historical volatility of the underlying equity. Convertibles also exhibit cyclical trading patterns, with more new issuances leading to cheaper pricing and attractive arbitrage opportunities for hedge fund managers.

The main challenge for convertible arbitrage managers is accessing and extracting the relatively inexpensive embedded optionality in convertibles while managing or hedging other risks in these securities. These risks include interest rate fluctuations, corporate issuer credit risk, and market risk (the risk that the stock price will decrease, diminishing the value of the embedded call option). To address these risks, managers employ various tools like interest rate derivatives, credit default swaps, short sales of the underlying stock, or purchasing put options. However, hedging can reduce the appeal of the convertible holding.

Convertible managers may embrace credit risk, avoiding hedging the corporate issuer's credit default risk and focusing on credit risk management. These are known as credit-oriented convertible managers. Alternatively, some managers may hedge credit risk but take a more directional view of the underlying stock and under hedge the equity exposure of the convertible. Another approach is to over-hedge equity risk to create a bearish stance on the underlying stock, providing more significant exposure to increased volatility. These are known as volatility-oriented convertible managers. In summary, multiple methods and styles exist for establishing convertible arbitrage exposures. Exhibit 8 highlights critical aspects of convertible bond arbitrage.

Risk Profile and Liquidity

• Convertible arbitrage managers aim to capitalize on this consistently underpriced implied volatility by employing delta hedging and engaging in gamma trading through short equity hedges against their long convertible positions.
• Liquidity challenges affect convertible arbitrage strategies in two primary ways: 1) the naturally limited liquidity of these securities due to their relatively small issuance sizes and inherent complexities, and 2) concerns about the availability and cost of borrowing the underlying equity for short selling.
• The attractiveness of convertible arbitrage strategies is at its peak during periods characterized by high convertible issuances, moderate volatility, and reasonable market liquidity. Conversely, the strategy may not perform as well during periods of pronounced credit weakness and general illiquidity, when the pricing of convertible securities is significantly influenced by supply and demand imbalances.

Leverage Usage

• Convertible arbitrage strategies employ high leverage levels due to the complexity of the multiple steps involved in executing these trades, such as short sales, credit default swap transactions, and interest rate hedges. Managers typically maintain convertible portfolios with a 300% long position versus a 200% short position to realize a modest ultimate gain from delta hedging. The lower level of short exposure is determined by the delta-adjusted equity exposure required from the short sales to offset the long convertible holdings.

Benchmarking

• Sub-indexes related to convertible arbitrage include the HFRX and HFRI FI-Convertible Arbitrage Indices, the Lipper TASS Convertible Arbitrage Index, the CISDM Convertible Arbitrage Index, and the Credit Suisse Convertible Arbitrage Index.

Strategy Implementation

A classic strategy in convertible bond arbitrage involves buying undervalued convertible bonds and taking short positions in overvalued underlying stocks. The number of shares to short is determined by the delta of the convertible bond, which is influenced by the conversion price relative to the current stock price. For bonds with low conversion prices, the delta is close to 1; for bonds with high conversion prices, the delta is closer to 0. This combination creates a delta-neutral position where small equity price changes keep the portfolio balanced.

However, as the stock price moves further, the delta hedge changes due to the positive convexity of the convertible. The strategy leaves the arbitrageur more exposed to equity when the stock price rises and less exposed when it falls. This gamma-driven exposure can be hedged by adjusting the size of the short stock hedge. The strategy is profitable with significant stock price swings and proper periodic rebalancing.

Challenges in convertible arbitrage include finding and borrowing shares for short selling, credit risk affecting bond valuation, losses due to time decay of the embedded call option during periods of low equity volatility, and market-wide changes in implied volatility.

Convertible arbitrage performs best when convertible issuance is high, market volatility is moderate, and there's ample liquidity for trading and position adjustments. However, when credit risks rise, it doesn't fare well during extreme market volatility. Additionally, hedge funds, which are significant players in this strategy, face redemption pressures during crises, adding left-tail risk during market stress.

Question

What conditions are most conducive to the success of convertible arbitrage strategies, and what factors can contribute to their underperformance?

1. High convertible issuance, low market volatility, and ample liquidity.
2. Moderate market volatility, ample liquidity, and high credit risks.
3. Extreme market volatility, ample liquidity, and high redemption pressures.

Solution

The correct answer is A.

The answer correctly identifies the conditions most conducive to convertible arbitrage strategies' success. When there is high convertible issuance, it implies a broader choice among convertible securities and generally cheaper prices. Low market volatility suggests a more stable market environment and ample liquidity makes trading and adjusting positions easier, which is essential for convertible arbitrage.

B is incorrect. The answer incorrectly includes “high credit risks,” which is not a condition conducive to the success of convertible arbitrage strategies.

C is incorrect. The answer includes “extreme market volatility” and “high redemption pressures,” which can contribute to underperformance, so it is not the ideal set of conditions for success.

Reading 38: Hedge Fund Strategies

Los 38 (d) Discuss investment characteristics, strategy implementation, and role in a portfolio of relative value hedge fund strategies.