Fixed Income Arbitrage
In this article we summarise the work of Jun Liu & Francis Longstaff on the risk and return characteristics of fixed income arbitrage.
We will see how fixed income arbitrage is implemented using a swap spread strategy; examine the underlying economics and reasons behind this investment strategy's popularity among hedge funds and investment banks on Wall Street. We will also see how the return indexes are created, analyze historic fixed income arbitrage hedge fund returns, and examine whether it follows a Taleb distribution, ie. picks up nickels in front of a steamroller.
SWAP SPREAD ARBITRAGE
At its core , fixed income arbitrage is a class of market-neutral investment strategies, designed to take advantage of the valuation differences between various fixed income assets or contracts.
One particular strategy to enforce this type of arbitrage is the swap spread, which can be viewed as buying corporate bonds and shorting treasuries. Since corporate yields are higher than treasury yields, this approach produces positive cash flow equal to the spread condition that by default doesn't take place.
RISK AND RETURN
This is not an arbitrage in the traditional sense because there is an indirect default risk involved in this strategy.
This is primarily due to spikes in libor rates caused by increases in the market volatility, in addition to the fact that arbitrageurs paying libor on swaps may incur large negative cash flows.
There is also the mark to market risk, which could force an arbitrageur with too little capital to unwind his position at a loss prior to convergence.
We will see that the historical data points to 1-6% of average annualised excess return, with a Sharpe ratio of 0.40 to 0.70. We'll also examine in detail the reason behind this positive excess return.
MECHANICS AND UNDERLYING ECONOMICS
The swap spread strategy performs well when the long term swap spread differs from the short term swap spread.
The strategy consists of two tracks. First, a market participant enters into a par swap and receives a fixed coupon rate CMS and pays the floating libor rate L.
Second, the market participant shorts a par treasury bond with the same maturity as the swap and invests the proceeds in the margin account, earning the repo rate r.
The cash flow from the second track consists of paying the fixed coupon rate on Treasury bonds, CMT, and receiving the repo rate from the margin account.
The cash flow from the two tracks shows that the participant receives a fixed annuity, SS = CMS - CMT, and pays the floating spread, L - r, (where L is the libor and r is the repo)
Hence, we see that swap spread arbitrage relies on whether the fixed annuity spread received will be greater than the floating spread to be paid. When the swap spread exceeds the average value of the floating spread, this strategy is said to be profitable.
REASON BEHIND THE POPULARITY OF SSA
It has been observed that the floating spread has historically demonstrated extremely low volatility, averaging 27.3 bps with a standard deviation of just 13.4 bps (from 1990-2004.
This makes fixed income arbitrage funds view the floating spread as constant and consider the swap spread stability as a nearly risk-free arbitrage whenever the swap spread exceeds the long term mean of the floating spread by 10-20 bps.
EVIDENCE FROM HISTORICAL DATA
The authors have provided the summary statistics of implementing swap spread trade.Listed below are some of the intriguing insights about the fixed income arbitrage strategy:
1. The difference between the swap spread and the expected average short term spread is frequently large enough to initialize the swap spread strategy.
2. The swap spread strategy is not an arbitrage in the classical sense; a minor fraction of trades do in fact end up with negative excess return. However, total excess returns from the trades are mostly positive.
3. Average total excess returns from the trades are all positive and often large in magnitude.
4. The loss is, by and large, modest as the worst total excess return expected by any trade is -2.21%.
5. Average monthly excess returns from the trades are all positive, ranging from 0.24 to 0.82. Monthly returns fluctuate from -11.2 to 12.58.
6. All swap spread strategies offer attractive Sharpe ratios to investors.
This paper establishes that the fixed income arbitrage strategies have noticeably positive excess returns. These excess returns range from 1 to 6%, depending on the horizon strategy.
This finding is in accordance with the results reported by various industry sources. It is also shown that all of the excess returns are due to market risks, as none of the alphas are significant.
Furthermore, the excess returns for fixed income arbitrage strategies are related to excess returns for the stock market, bank stocks, and treasury and corporate bonds. This suggests that the risk for a major financial event is a risk that is priced throughout the many financial markets.
Written by Mithelesh Kumar
Edited by Gihyen Eom, Michael Ding, Bryan Xiao & Alexander Fleiss