Fixed Income Relative Value
Understanding Fixed Income Relative Value
In fixed income relative value trading, investors seek to identify and exploit apparent deviations from no-arbitrage relationships. For instance, an expensive bond would be shorted while a cheap bond would be purchased. Bonds emitted by the same issuer with the same cash flows should have the same prices and yields. However, deviations from the law of one price are prevalent in the bond market. These deviations can be large or small, but they are rarely absent.
Deviations in fixed income relative value are caused by funding market frictions and bond market segmentations. The profit motive of arbitrageurs can reduce deviations when funding constraints are loose and when arbitrage capital is abundant. Conversely, deviations will be larger and more persistent when funding constraints are tight, and arbitrage capital is scarce.
Causes of Fixed Income Relative Value
The causes of fixed income relative value are limited arbitrage capital and aversion to the risk of persistent divergence. The law of one price dictates that bonds with the same risk should have the same expected returns. However, deviations from the law of one price are pervasive in the bond market, revealing limits of arbitrage due to funding market frictions and bond market segmentations.
Methods of Fixed Income Relative Value
The most common strategy to exploit deviations from the law of one price is the so-called relative value trade. Relative value is based on the idea that bonds with the same risk should have the same expected returns. A relative value trade may involve a portfolio of bonds replicating the duration and convexity of the target bond. This is different from replicating the cash flows since exact replication of a coupon bond is typically much costlier.
Existing approaches to measure relative value rely on parametric models, such as Hu, Pan and Wang's noise index. These models use a static parametric yield curve to show an index of fitting errors or the "noise" measure. Another measure of deviations is based on the relative value of bonds, which is model-free. For any bond in the sample, a small number of comparable bonds are used to form a replicating portfolio with the same duration and convexity. The relative value for that bond is the difference between its yield and that of the replicating portfolio.
Profitability of Fixed Income Relative Value
A measure capable of identifying deviations from limits of arbitrage should generate positive returns over time. Using non-parametric relative value as a trading signal for a pseudo-trading strategy produces significant excess returns in the US Treasury bond market. In contrast, trading measures based on parametric yield curve models, such as Hu, Pan and Wang's measure, generate significantly lower returns and signal a large number of ultimately unprofitable trades.
Indices of Fixed Income Relative Value
Higher returns from pseudo-trading strategies mean arbitrageurs face greater costs or greater risk when implementing these strategies. An aggregate relative value index is proposed to compute deviations from arbitrage relationships for several large sovereign issuers. Higher values for the index indicate that deviations from arbitrage relationships are larger on average. These indices are available publicly and updated regularly on the Bank of Canada's website.
Fixed Income Relative Value in Practice
Fixed income relative value trading can be challenging due to the small arbitrage opportunities relative to the notional of the instruments traded. As a result, fixed income relative value hedge funds are often highly leveraged. Even with significant leverage, the short-term volatility of fixed income relative value funds can be quite low. The challenge for fixed income relative value funds is often in identifying tail risks and measuring liquidity risk.
Trading Opportunities in Fixed Income Relative Value
Trading opportunities in fixed income relative value are often based on similar exposures to duration, convexity, and credit risk. For example, on-the-run versus off-the-run government bonds represent a classic fixed income relative value trade. The strategy is based on the premise that the on-the-run bond should be more expensive than the off-the-run bond, given the former's greater liquidity.
Another example of fixed income relative value is the trade between Treasuries and interest rate swaps. The trade is based on the premise that Treasuries and swaps should be equal in price. However, in practice, they often diverge due to market inefficiencies, creating an opportunity for arbitrage.
Risks in Fixed Income Relative Value Trading
The primary risk in fixed income relative value trading is tail risk. Tail risk refers to the risk of extreme losses occurring beyond what is predicted by the normal distribution. In fixed income relative value trading, tail risks can be caused by market illiquidity, sudden shifts in interest rates, or unexpected changes in market sentiment.
Liquidity risk is another important risk to consider in fixed income relative value trading. Liquidity risk refers to the risk of not being able to sell an asset at a fair price when needed. In fixed income relative value trading, liquidity risk can be caused by sudden changes in market sentiment, unexpected shifts in interest rates, or a lack of buyer interest.
Advantages of Fixed Income Relative Value Trading
One of the main advantages of fixed income relative value trading is its ability to generate steady returns, even during periods of market volatility. Fixed income relative value trades are often based on long-term market inefficiencies that persist over time. As a result, fixed income relative value trading can provide a hedge against market volatility, helping to smooth out returns over time.
Another advantage of fixed income relative value trading is its ability to provide diversification to a portfolio. Fixed income relative value trading is often uncorrelated with other asset classes, providing a source of diversification that can help reduce overall portfolio risk.
Challenges of Fixed Income Relative Value Trading
One of the main challenges of fixed income relative value trading is the need for specialized expertise. Fixed income relative value trades often require a deep understanding of market inefficiencies and market liquidity, as well as an ability to identify and exploit these inefficiencies.
Another challenge of fixed income relative value trading is the need for significant leverage. Fixed income relative value trades often involve small arbitrage opportunities relative to the notional of the instruments traded. As a result, fixed income relative value hedge funds are often highly leveraged, which can amplify losses in the event of unexpected market moves.
Conclusion
Fixed income relative value is a type of hedge fund trading that seeks to profit by identifying arbitrage opportunities between similar fixed-income instruments. Although the strategy can be challenging, it can provide steady returns and diversification to a portfolio. The primary risks in fixed income relative value trading are tail risk and liquidity risk, and the main challenges are the need for specialized expertise and significant leverage. By understanding the causes, methods, and profitability of fixed income relative value, investors can make informed decisions about incorporating this strategy into their investment portfolios.