Fixed-Income Arbitrage

Updated on March 13, 2024
Article byRutan Bhattacharyya
Edited byRutan Bhattacharyya
Reviewed byDheeraj Vaidya, CFA, FRM

What Is Fixed-Income Arbitrage?

Fixed-income arbitrage is a trading strategy that involves generating profits from price differences materializing in different bonds or any other interest rate security. Primarily investment banks and hedge funds utilize this technique to make financial gains for their investors irrespective of whether the overall bond market trends lower or higher.  

Fixed-Income Arbitrage

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When utilizing this strategy, investors take opposing positions in the market to make the most of fixed-income securities’ price differences while restricting interest rate risk. Some common debt securities used by arbitrageurs include corporate bonds, mortgage-backed securities, government bonds, and municipal bonds. They utilize complex fixed-income instruments as well, for example, credit default swaps (CDS).

Key Takeaways

  • Fixed-income arbitrage refers to a popular trading strategy that involves taking advantage of the price differences concerning fixed-income securities. Institutional investors, for example, investment banks, use this strategy to make financial gains by capitalizing on market inefficiencies.
  • There are various factors one must take into account before carrying out fixed-income arbitrage trading. Some of them are liquidity, regulation, market segmentation, and volatility.
  • Some noteworthy fixed-income arbitrage strategies include credit spread arbitrage and capital structure arbitrage.
  • Examples of debt securities associated with this trading strategy include corporate bonds, credit default swaps, and mortgage-backed securities.

Fixed-Income Arbitrage Explained

Fixed-income arbitrage refers to a strategy that exploits price differences concerning different debt instruments to generate profits. Traders looking to generate profits regardless of the overall market trend can opt for this approach.

Fulfillment of these two conditions is necessary for this technique to work :

  1. The debt instruments must be liquid so that one can buy and sell them easily.
  2. Securities used for the strategy must be extremely similar with very minimal differences.

After the fulfillment of the above conditions, individuals must go long on the overpriced security and take a short position in the underpriced financial instrument. Note that simultaneously executing both trades would allow them to lock in the difference in price. Then, once the securities are subject to a correction, they can settle both trades and realize the profits.

On account of purchasing securities and selling securities simultaneously, there’s always a chance of a trader incurring losses as a result of a price decrease. Moreover, there’s the risk of the issuer not being able to make the fixed payments or failing to repay the full investment amount at the term’s end. That said, one must remember that it is a market-neutral strategy. So, one can generate profits using this technique irrespective of whether the market trend is upward or downward.

Since the difference in price does not exist for a long period, individuals or organizations have a short window to utilize the strategy. Failing to utilize the technique in time can lead to losses. Hence, one must proceed with caution before opting for this strategy.

Factors

Let us look at some key factors that individuals or organizations engaging in fixed-income arbitrage trading must consider.

  1. Market Segmentation: This factor is a worry for individuals using such a strategy as it can be challenging to monitor the different parts of the yield curve and identify arbitrage opportunities. Hence, in financial institutions, the fixed-income desk has different traders monitoring different sections of the yield curve. For example, a few traders may focus on date. Some may look at the yield curve’s middle portion (2 to 5 years), and others may look at the curve’s long end (0-30 years).
  2. Liquidity: The more liquidity in a market, the more straightforward it is for people to implement this strategy. 
  3. Regulation: This factor influences what kind of debt instrument a trader can hold. For example, a few legislations may require individuals and organizations not to exceed a specific exposure to junk bonds or other high-yield debt instruments. This is because the credit risk associated with such financial instruments is high. 
  4. Volatility: Significant fluctuations in the market have a heavy impact on such a strategy’s profitability.

Strategies

Three popular fixed-income arbitrage strategies are as follows:

  1. Yield Curve Arbitrage: This strategy involves capitalizing on the yield variations along the yield curve. One can make financial gains from the yield spread changes by simultaneously purchasing and selling bonds having different maturity periods.
  2. Credit Spread Arbitrage: This strategy focuses on the yield difference between bonds having different credit qualities. One using this technique shorts bonds having lower credit quality while taking a long position in bonds having higher credit quality in an attempt to capture the credit or yield spread.
  3. Swap-Spread Arbitrage: In the case of such a strategy, individuals need to take opposing positions in a treasury bond, repo rate, and interest rate swap to generate profits between the swap spread.
  4. Capital Structure Arbitrage: This strategy used by fixed-income arbitrage hedge funds involves taking advantage of a bond’s conversion feature and a stock’s price movement. Simply put, individuals, investment banks, or hedge funds utilizing this method purchase convertible bonds and simultaneously short sell the underlying stock.

Examples

Let us look at a few fixed-income arbitrage examples to understand the concept better.

Example #1

Suppose Company ABC has a convertible bond. XYZ hedge fund decides to take advantage of any potential price difference between the price of the fixed-income security and the underlying stock. To implement the fixed-income arbitrage strategy, XYZ takes a long position in the convertible bond and simultaneously goes short on the ABC stock. The stock price falls, generating gains for the hedge fund, while the long position witnesses only a minor correction. Thus, the difference between the long and short position prices is XYZ’s profit.

Example #2

In June 2021, Credere Capital, a fixed-income arbitrage hedge fund focusing on convertible arbitrage, announced that it would be launching a higher-return, higher-volatility version of the organization’s Trium Credere strategy later that year to cater to the increasing demand of investors concerning such strategies. The new strategy would trade the identical relative value and arbitrage as the existing Trium Credere flagship strategy, allocating funds to different derivatives markets and hybrid financial instruments. The difference was that the new strategy would target roughly double the exposure.

Fixed-Income Arbitrage vs Swap-Spread Arbitrage

Individuals new to trading often confuse fixed-income and swap-spread arbitrage. To clear all doubts, they must understand their key differences, which are as follows:

Fixed-Income ArbitrageSwap-Spread Arbitrage
Such a strategy involves profiting from the price difference in different interest rate securities.This strategy involves capitalizing on the difference between the treasury rate and the swap rate.
This is a broader concept when compared to the swap-spread arbitrage strategy.It is a narrower concept; this strategy falls under the umbrella of fixed-income arbitrage.

Frequently Asked Questions (FAQs)

1. What is the application of fixed-income arbitrage?

This strategy can be applicable in both rising and falling markets. That said, comprehending the yield curve structure and identifying the relative valuation difference between debt instruments is vital to ensure the technique can generate profits. 

2. Do retail investors use the fixed-income arbitrage strategy?

No, usually, retail investors do not engage in this type of arbitrage. This is because the price differential is typically negligible, and there are transaction-related charges as well. It means individuals would require a substantial amount of capital to make profits, or else the transaction costs would wipe out the profits, if any.

3. What are the advantages of fixed-income arbitrage?

Some benefits of this strategy are as follows:
– It helps the market become more robust and efficient
– This strategy allows institutional investors to generate profits quickly.
– The strategy is useable regardless of the overall market trend.

4. What is the disadvantage of fixed-income arbitrage?

If there aren’t many arbitrage opportunities available in the market, the strategy offers limited return potential.

This article has been a guide to what is Fixed-Income Arbitrage. Here, we explain its strategies, examples, factors, and differences with swap-spread arbitrage. You may also find some useful articles here –

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