Investment Strategies of Hedge Funds

7

Fixed Income Arbitrage

Figure 7.1 will surprise people who think that the fixed income market consists mainly of treasuries. This figure shows that treasuries account for only 16.6 % of all bonds outstanding in the United States as of 30th September 2004. In fact, treasuries are surpassed by two other bond classes in terms of size: corporate bonds represent 20.1 %, but maybe more surprising is that 23.4 % is made up of mortgage bonds. Treasuries rank first in terms of daily average trading volumes. In the first nine months of 2003, the notes issued by the US Treasury were by far the most traded debt securities (Figure 7.2).

According to the LIPPER TASS database, on 31st December 2004, fixed income arbitrage funds accounted for 7 % of the hedge fund industry. Diverse trading strategies can be identified:

1. Issuance driven arbitrage (snap trade): the arbitrageur anticipates that the prices of the latest treasuries issued (on-the-run) and the prices of the next to last treasuries having very similar maturity dates will converge when the demand for on-the-run treasuries slows down as a result of a new treasury issue.

2. Yield curve arbitrage: the fund manager expects changes in the slope of the various areas of a specific interest rate curve. A type of yield curve arbitrage is the so called butterfly trade, whereby you open a position having a relative value between a seven year treasury that is more expensive with respect to two treasuries at six and eight years.

3. Intermarket ...