What is Fixed Income Arbitrage ?

Before diving into this hedge fund strategy, let us remind ourselves of the basics: when interest rates fall, bond prices rise. The opposite is true when interest rates rise.

To understand this strategy, we assume that bond portfolio managers are skilled in:

  • Anticipating the future direction of interest rates.
  • Pricing credit risk of the bond. ‘Credit Risk’ is the risk that the bond issuer (the borrower) will fail to make interest payments or principal repayment. It is typically calculated as the difference in yield-to-maturity (YTM) of a ‘risky bond’ and the YTM of a risk-free comparable government bond. 

This strategy relies on the premise that the credit risk of a bond is priced inefficiently – allowing the bond manager to exploit these inefficiencies and thus make an abnormal return. 

In this strategy, the arbitrageur (bond manager) uses two instruments: 

  • A company’s bond (let’s call it the ‘risky bond’) 
  • A government bond with the same term-to-maturity

When the bond manager feels the credit risk is priced higher than it’s supposed to be they would:

  • Sell short the government bond
  • Purchase the risky bond 

Over time, the credit risk of the ‘risky’ bond eventually comes down to its correct pricing – increasing the value of the risky bond. As the arbitrageur is long the ‘risky bond’, they make a capital gain. 

The inverse is done, when the credit spread is narrower than what it’s supposed to be. In this scenario, the arbitrageur: 

  • Purchases the government bond
  • Sells short the risky bond. 

When the credit risk of the ‘risky’ bond, eventually increases to its correct price- the value of the bond decreases. The arbitrageur then can exit by closing their short position. Hence making a capital gain. 

Please comment below for any feedback, suggestions, or opinions

Published by The Street Pandit

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