Capitalising on volatility

Hedge Funds Review finds out how fixed-income arbitrage managers are capitalising on a volatile debt market for opportunities

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There are plenty of good opportunities to be found in fixed-income arbitrage at the moment. The trouble for investors is finding a fund as the universe for the strategy has shrunk.

“After March 2008 there’s much less of what I’d call traditional fixed-income arbitrage,” says Chris Manser, global fund of hedge fund activities head at Axa Investment Managers. “I don’t think it’s dead but for the funds that are focusing 100% of their attention on it, it’s going to be difficult to run them going forward.”

What Manser would describe as “traditional” are the more value-orientated managers. Others describe the strategy as aiming to exploit inefficiencies in the relationship between government bonds and their related derivatives.

Classically, fixed-income arbitrage managers exploit the relationship between supply and demand in the price of cash and futures by buying one and selling the other. Eventually the futures contract expires and prices converge.

Post 2008 some extend the definition to funds arbitraging corporate bonds and credit.

Jeremy Corn, founder and manager at Sanctum FI in London, says: “It’s not very easy to define the universe. The problem that people face when they look at the strategy is the wide divergences in terms of what people are trading and the risks they’re running. Often when you’re looking at two funds it’s like comparing apples and oranges.”

Both Manser and Corn believe that many managers have shifted away from pure fixed-income arbitrage, or fixed-income relative value as it can also be known. Instead managers are now pursuing more macro strategies that include an element of arbitrage.

As in so many other areas of the industry that have undergone change, the cause of this move can be traced back to the cyclical nature of the market. Manser explains that in 2006 and 2007 pension funds “were piling into 30-year gilts to hedge their long-term liabilities”.

“That had the effect of driving down yields to such low levels and people were basically playing the mean reversion in that,” he says. According to Manser many fixed-income arbitrage managers entered the trade too early and suffered from  significant mark-to-market losses. Many got stopped out before the trade turned.

The effect of this market activity was significant enough that there has been no reversion to the mean since 2008. As a result managers have been forced to focus more on the macro side of things rather than on micro strategies such as butterfly trades on a yield curve.

However, there are some managers who are still focusing on the fixed-income arbitrage market in quite a micro way. Sanctum, for example, looks exclusively at G10 government bonds and predominantly at the US treasuries market.

“What we’re trading is very much idiosyncratic and trying to exploit bond-specific distortions relative to other bonds in the same market,” says Corn, adding that Sanctum also tries to hedge out directionality and yield curve exposure in its trades.

The company does that by buying or selling a swap with the same duration as the bond it is short or long in. “Every bond we’re long we’ll be short another or short a futures contract. You can’t eliminate everything but we try as much as possible to eliminate those risks,” Corn says.

At the more macro level, Jonathan Duensing at US fixed-income specialists Smith Breeden says the company views the strategy as a means to exploit relative value opportunities in a range of asset classes, including corporate credit, and would also look at relationships between interest rates going forward.

“Now we’re actually getting into part of the market cycle when we feel that more relative value opportunities are coming back on to the radar screen,” says Duensing.

“We’re excited about the possibility of markets differentiating between asset classes and differentiating between different types of risk that exist in the market,” he adds.

Stephen Rothwell of emerging markets specialists Argo thinks managers will need to make judicious use of longs and shorts this year in order to make money, pointing to continued uncertainty over interest rates.

“If interest rates rise, it’s a sign that the real economy is continuing to recover and that has to be a good thing,” Rothwell points out. “The danger is you’re stuck in a trading range where recovery is stuttering and there’s little leeway on the monetary policy side.”

He says being able to trade nimbly will be important during the year if yield spreads widen suddenly. However, other managers, such as Concise Capital’s Tom Krasner, say spreads have only widened by a few basis points and optimism has reduced since the start of the year.

Fixed-income arbitrage is a strategy that particularly benefits from a volatile, uncertain market. When there is turmoil, market inefficiencies are accentuated and there are more opportunities, giving managers more options for trades.

“We actually revised our target at the start of 2009 because we felt the environment was likely to be very beneficial for what we do,” says Corn. “In government markets there was a massive amount of supply. For a very micro-focused fund like us that creates a lot of opportunity because of the distortions and dislocations supply can bring into the market.”

Last year turned out to be a solid year for fixed-income arbitrage managers. Both of the two investable indexes following the strategy – the Credit Suisse/Tremont Hedge Fund Index and the Lyxor Alternative Indexes – had good, if not exceptional, years.

There were no negative months on the Credit Suisse Index which finished 2009 up 28.2%. Lyxor had a negative October down 2.17% but ended 2009 up 16.8%.

Corn says things were different when Sanctum launched in 2003 as volatility was dropping, another cause of managers leaving pure fixed-income relative value funds and moving into more macro-type trading.

Quantitative easing is also a plus point for fixed-income arbitrageurs. It introduced a lot of opportunities into the market and now governments are ending the easing programmes. Corn says: “With quantitative easing coming to an end that should if anything increase volatility because you’ve taken out of the market the biggest buyer of securities that we’ve ever seen.”

Slow recovery
Managers believe the markets could take longer to come out of the crisis than in previous cycles. “People are still scared and they’re still very much shell-shocked. There are still a tremendous amount of people with their money invested in cash,” notes Krasner.

“If you look long term at high-yield cycles and the history of credit spreads when you have a shock like we’ve had in 2008 and a contraction afterwards, you tend to have a period of normality. The period of normality usually lasts a good four to five years. In this cycle I would argue that because the recession is so deep it’s likely that the trough-to-trough cycle will last seven to eight years rather than five years,” Krasner adds.

Duensing says although there have been signs of a recovery, the increased emphasis on risk management by the investment community at large has led to the implementation of tighter risk controls and a stop-loss mentality.

“From that standpoint we do think that that mentality is going to create positive opportunities and even some volatility. What we’d other-wise be seeing is a low-volatility part of the cycle,” he says.

Another positive factor for the strategy is the effect of the credit crisis on both the banking and wider hedge fund sectors. Some struggling banks were forced to close their proprietary trading desks and many funds, including a significant number in this strategy, closed down. “The opportunity set is much richer today,” says Manser.

Basil Williams of New York’s Concordia Advisors agrees, saying the fall in activity from prop desks and hedge funds has increased the return per dollar of investment in fixed-income arbitrage strategies, thanks to less competition over trades.

While a number of funds have fallen by the wayside during the credit crunch, luckily for fixed-income arbitrage there has not been a repeat of the spectacular blow-up of Long Term Capital Management (LTCM) in the late 1990s.

Due to its collapse LTCM is possibly the best-known fixed-income arbitrage fund. Managers now believe a similar meltdown is unlikely.

“A lot of what’s changed from the LTCM days is the overall leverage in the system,” says Duensing.

Corn agrees. He says because there are more opportunities available in the market at present managers can still produce returns without having to resort to the high levels of leverage common when LTCM was trading.

Manser recalls that returns continued to be good for surviving funds after LTCM. This helped investors to forgive and forget. “Ultimately I don’t think it was all that damaging because afterwards these funds continued to make money,” he says.

Investors into fixed-income arbitrage funds are as keen on liquidity as those investing elsewhere in the hedge fund universe. That has led to less leverage although Duensing adds it is slowly coming back into the system.

Funds are also finding it easier to gain financing through sale-and-repurchase agreements, otherwise known as repos. During the crisis liquidity in the repo markets dried up, but last year some liquidity returned.

For funds of funds like Axa, the lower levels of leverage are attractive propositions. Manser says increased diversification and appropriate sizing of trades is important.

“I believe there are a lot of trades that have historically made money. But you need to be able to either achieve them with realistic levels of leverage or you will have to have enough diversification, or you have to size them appropriately,” he says.

“If it’s just a small part of what you’re doing in a diversified way you’ll have better chances to hold through the trade,” adds Manser.

He thinks Axa will remain exposed to fixed-income relative value funds in the future.

“It’s a decent proposition in our portfolio and has generally been very profitable over the last two years or so. Our expectations are excellent going forward,” Manser says.

“With all the government bond issuance that you’re going to see over the next years it should continue to be a very interesting area,” he concludes.

Able to arbitrage

A good fixed-income arbitrage fund needs a solid team of professionals. Managers say experience is important, backed up by a sizeable operations and risk management infrastructure.

Axa Investment Management’s Chris Manser says he would expect a manager to pay attention to issues such as position sizing and stress testing as well as how the fund is financed.

Smith Breeden’s Jonathan Duensing believes a fixed-income arbitrage fund should be managed by a team that blends strong quantitative analysis skills with qualitative ability.

A “strong macro opinion” is also helpful in order to be able to manage situations when previously uncorrelated trades suddenly become correlated through market movements. Knowledge of what is influencing asset prices and policy-level decisions is also key in this area.