The management of Fixed Income Securities as an asset class
has been transformed by traders and risk managers that have
typically migrated from investment banks to launch and manage
hedge funds. In so doing they bring product, portfolio and
risk management skills that lie outside the boundaries of
traditional fund management and make it difficult for traditional
managers to compete in the a changing environment. These hedge
funds bring investors an absolute return focus, whilst utilizing
the full 'toolkit' of fixed income and derivative products
to extract relative value and maximise arbitrage opportunities.
WHAT ARE FIXED INTEREST SECURITIES?
Fixed interest (or income) securities are typically issued
by borrowers who require funds for extended periods of time.
The issuer of these securities, usually a corporation, bank
or government, is obliged to make a series of specified payments
to the holder of the income security over a specific period
of time. At the end of this period, the initial amount borrowed
will be fully repaid.
Investors can purchase these borrowings to receive a regular
income stream and the eventual full return of their principal
Fixed interest securities are fundamentally different from
shares, but can be equally important for an effective balanced
portfolio. Shares represent part ownership of a company, however,
when you buy fixed interest securities you are making a loan
to a company, for which you will receive scheduled interest
payments, and finally you receive the principal of the loan
The term "fixed interest securities" covers a range
of interest bearing debt securities, including but not limited
to bonds; debentures; convertible notes and capital notes.
Many investors choose fixed interest securities over shares
because they want a reliable income stream, called the interest
coupon - rather than relying on unpredictable nature of company
dividends. Moreover, the more risk adverse fixed income investors
also look to distance themselves from the price volatility
associated with shares.
Prudent investors use fixed interest instruments as both
a complement and supplement to other investments to reduce
and diversify the risk in their underlying portfolios.
WHAT ABOUT THE RISKS?
When investing in fixed interest securities, you take the
risk of having the market value of your investment decrease.
In addition, it is also possible that the issuer of the security
may not be able to keep up interest payments or repay the
capital sum on maturity.
Prices of fixed interest securities are impacted by a number
of factors, including the creditworthiness of the issuer;
the general level of market interest rates; the coupon size
and structure of the underlying security.
Generally, if interest rates increase, the security price
of fixed interest security will decrease. This is because
investors will be reluctant to purchase bonds paying, say,
3% if the prevailing market interest rate for a comparable
bond is 4.5%.
When investing in high rated government bonds, most investors
consider there to be virtually no risk of the issuer failing
to pay interest or, most importantly, return your capital.
However, with corporate bonds, there is a greater chance of
adverse conditions impacting the company - which could mean
that your interest payments and return of capital are uncertain.
To compensate for this, investments in fixed interest securities
issued by companies of low credit quality tend to offer investors
In the event of the collapse of the company, creditors (including
fixed interest security holders) rank higher than shareholders
to receive a return on their investment.
FIXED INTEREST ARBITRAGE
Hedge Fund Managers involved in Fixed Income Arbitrage have
a goal of delivering investors solid returns, with minimal
monthly volatility. Importantly, such managers also have in
mind the concept of "capital preservation". To achieve
the stated goals in a consistent manner, the hedge fund manager
looks to take both long (bought) and short (sold) positions
in fixed income securities.
The classic definition of an arbitrager is the simultaneous
purchase and sell of a security in order to profit from a
differential in the price. In practice, it is difficult to
obtain a "pure or risk-free arbitrage", which implies
some level of risk is assumed when executing the arbitrage
strategy. The arbitrageur will look to purchase the perceived
undervalued security and go short the perceived overvalued
There are many forms of fixed interest arbitrage opportunities
for hedge fund managers to get involved in, including but
not limited to, government bond yield curve arbitrage; mortgage
backed security arbitrage, convertible bond arbitrage and
corporate bond arbitrage.
By way of example, in corporate bond arbitrage, the hedge
fund manager looks to take advantage of perceived misprising
in the capital structure of related securities issue by an
issuer. The capital structure of a company can be decomposed
into senior debt, subordinated debt and equity.
Another commonly employed instrument in arbitrage strategies
is the use of credit derivatives of the underlying issuer
to express long and short views.
Lets assume that arbitrager perceives that the subordinated
debt of XYZ Company is trading cheap to the underlying senior
debt of XYZ Company. To execute the long/short strategy, the
arbitrager will invest in the subordinated debt and short
sell the senior debt of XYZ Company. As mentioned, this is
not a pure arbitrage. The strategy will profit from a narrowing
in the yield differential of the two instruments.
Anomalies occur in yield curves and instruments of the same
underlying issuer for varied reasons, including differing
investor appetite; liquidity; tax and regulatory reasons.
There are a number of risks involved in executing an arbitrage
position. One of the major risks is setting both legs simultaneously.
The same can be said when unwinding positions.
Prior to establishing a strategy, a major component in the
analysis is the holding or carry cost of combined positions.
In addition, the arbitrager must consider the impact of not
being able to borrow securities (the trader needs to be able
to deliver securities he does not own) at an acceptable cost
the "short sold" leg of the strategy. These are
critical factors, which influence the arbitrager's ability
to profit from a perceived anomaly. A major fear of all arbitrageurs
is being forced out of a position, due to the inability to
borrow "short sold" securities.