What is Fixed Income Arbitrage?

Large scale investors, such as institutional participants and hedge funds, often employ arbitrage strategies to make profits in addition to trading financial assets. These strategies can be used to reduce the risks associated with investing options and provide investors with fair returns.

Fixed income arbitrage strategies are a popular way to profit from minor price differences between asset classes. Continue reading to learn more about fixed income arbitrage.

What is Fixed Income Arbitrage?

Before we get into the details of fixed income arbitrage, let's first look at fixed income securities.

Fixed income security is a financial instrument where the issuer is required to pay periodic fixed interest payments to the investor for a specified time period. Fixed income securities include bank deposits, bonds, debentures and treasury bills. When compared to stocks, these securities are often considered low-risk investments. Many fixed income securities such as debentures, convertible bond, and Treasury bills can be listed and traded on the market in the same way as a company's stock.

Now that you know what fixed income securities actually are, let us get back to fixed-income arbitrage strategies.

Fixed income arbitrage allows investors to profit from the price differences between fixed income securities. This strategy requires you to take a long position on a security and then short it to capture the small price difference. Fixed income arbitrage strategies are usually market-neutral. This means you can enjoy returns regardless of the market's future swings.

Fixed income arbitrage requires that investors use it quickly because price differences in fixed-income securities don't usually last long. It is possible to miss an opportunity and even lose money if you fail to do so. These situations increase the risk associated with fixed income arbitrage strategies, so it is important to exercise caution when dealing with them.

How fixed income arbitrage works?

Two conditions are required for fixed income arbitrage strategies that work correctly.

Fixed income securities must be liquid to allow you to purchase and sell them on the market with relative ease.

- Securities that will be used in arbitrage strategies should be very similar with very few differences.

After you have satisfied these conditions, all you need to do is to take a long position in the security that is too expensive and then take a shorter position in the security that is less expensive. You can't execute both trades simultaneously to lock in the price difference. Both trades can be settled once the price of both securities has corrected to realize the profit.

Let's now see how this strategy works.

Fixed Income Arbitrage An example

Consider a fixed income security such as a convertible bond. The price difference between convertible bond's market price and underlying stock can be used to your advantage. You will need to hold a convertible bond long and simultaneously a stock short. The short position will see significant price corrections, while the long would experience gains. Your profit would be the difference in the prices of the short and long positions.

Alternativly, you can shorten the convertible bond and take a long position in the underlying stock if you feel the price is too high.

Convertible bond arbitrage is one great example of fixed income arbitrage. Swap-spread arbitrage and yield curve are other examples of fixed income arbitrage.

Conclusion

Fixed income arbitrage strategies can be lucrative but they come with significant risk. An investor must have large amounts of capital to be able to execute a fixed-income arbitrage. These are the two main reasons large institutional investors, such as hedge funds, private equity and investment banks, use these investment strategies.