One the adages coined about fixed-income arbitrage is that it is like "picking up nickels in front of steamrollers." I love the visuals associated with this phrase, but disagree with the premise. This may seem odd coming from someone who has been associated with divergent trading, but I appreciate the unique portfolio features derived from arbitrage or fair value strategies in the fixed-income markets. The evidence also suggest that fixed income arbitrage may have negative skew but also generates positive alpha. The real risk issue may be the exuberance of using leverage to pick up too many nickels and not looking for steamrollers.
Arbitrage trading is essentially a convergent trading strategy and should be uncorrelated with the trend-following found in most CTA's and classified as divergent trading. Fixed income arbitrage can be classified as non-directional or at least the majority of returns is driven by alpha not related mainly from rate moves. Consequently, quasi-arbitrage strategies have important diversification properties for any hedge fund portfolio as especially for those that are looking for market dislocations.
Focusing on fixed-income trading, we can identify a number of fair value strategies that have different distribution and portfolio characteristics. This is review in a Bank of Canada paper. These include: swap spread, yield curve, mortgage, volatility, and capital structure arbitrage. This work suggests that there is significant alpha capture with these strategies after accounting for stock and bond moves. However, they also find that the more complex or sophisticated arbitrage strategies produce more alpha than simple strategies. Skill matters. Holding these unique skill driven strategies in a portfolio is beneficial especially if the alternatives in the portfolio are directional strategies.
Our view is that arbitrage strategies become dangerous when they are over-levered and do not account for distribution properties like negative skew. Skill matters, but the key to fixed income is understanding whether the trade is liquidity or event driven. If the premium from trading is based on liquidity, there is the threat that liquidity will not be available when needed. If the threat is event driven, there is the risk that a surprise event will drive price further away from fair value. Over leverage increases the liquidity exposure and event exposure. If there is a high level of risk to liquidity and event risk, then other strategies have to be held that improve with changes in event risk. Versus the fixed income market, this means holding something that does well when there is more global macro dislocations.
Arbitrage trading is essentially a convergent trading strategy and should be uncorrelated with the trend-following found in most CTA's and classified as divergent trading. Fixed income arbitrage can be classified as non-directional or at least the majority of returns is driven by alpha not related mainly from rate moves. Consequently, quasi-arbitrage strategies have important diversification properties for any hedge fund portfolio as especially for those that are looking for market dislocations.
Focusing on fixed-income trading, we can identify a number of fair value strategies that have different distribution and portfolio characteristics. This is review in a Bank of Canada paper. These include: swap spread, yield curve, mortgage, volatility, and capital structure arbitrage. This work suggests that there is significant alpha capture with these strategies after accounting for stock and bond moves. However, they also find that the more complex or sophisticated arbitrage strategies produce more alpha than simple strategies. Skill matters. Holding these unique skill driven strategies in a portfolio is beneficial especially if the alternatives in the portfolio are directional strategies.
Our view is that arbitrage strategies become dangerous when they are over-levered and do not account for distribution properties like negative skew. Skill matters, but the key to fixed income is understanding whether the trade is liquidity or event driven. If the premium from trading is based on liquidity, there is the threat that liquidity will not be available when needed. If the threat is event driven, there is the risk that a surprise event will drive price further away from fair value. Over leverage increases the liquidity exposure and event exposure. If there is a high level of risk to liquidity and event risk, then other strategies have to be held that improve with changes in event risk. Versus the fixed income market, this means holding something that does well when there is more global macro dislocations.
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