It was toward the end of 2011, when Europe was getting hit with a blast of bad financial news.

Big banks were scarily in the red and their respective governments were getting dragged into the mess, trying to save their sinking financial systems. Borrowing costs reached double digits in the continent’s most stressed peripheral markets, creating the scary prospect of state and bank debt default.
Then in 2012, hope was instilled in the markets when the European Central Bank announced it would do whatever it takes to save Europe. 

More cash was plowed into depressed sovereigns through the bank’s Securities Market Program, and its Long-Term Refinancing Operation, which lent more than a $1 trillion at very low costs to banks, ended up being used to purchase more sovereigns. 

These moves brought down interest rates like a shot of financial adrenaline, stabilizing bank balance sheets and calming investors.

But the crisis and subsequent government intervention also created pricing irregularities—a market inefficiency that didn’t go unnoticed by some investors.
Bob Treue, manager of the 13-year-old Barnegat Fund in Hoboken, N.J., whose annualized returns have averaged 18.52%, saw opportunities in asymmetric market moves between like securities. 

It was a classic fixed-income arbitrage play.

Complicated in detail, the essence of such investments, however, is pretty basic: locking in the spread between two very similar securities that have become divergently priced and hedging out much of the risk that can move against an investor. The trade collects an attractive yield while waiting for values to normalize back to traditional levels.

Sovereign Gap
Before the European Central Bank came to the rescue, “we were seeing inflation-protected sovereigns selling off faster than their nominal counterparts, both of the same maturities,” Treue says. This was caused in part by the negative outlook on Italian government debt, which threatened to push the country’s credit rating to below A-minus. If this threshold were broken, it would’ve triggered Italian bond expulsion from the Barclays Euro Government Inflation-Linked Bond index. (Italian bonds represent a much larger segment of this index than other indices tracking euro zone sovereigns.)

Anticipating expulsion was a fait accompli; many investors started fleeing these bonds, hoping to get out before panic selling started. The result: Inflation-protected Italian bonds were yielding nearly as much as the traditional nominal debt of the same maturity that didn’t come with inflation protection.

The arbitrage Treue set up in late January 2012, before the European Central Bank’s game-changing pronouncement, had three legs: 
Barnegat purchased inflation-protected 2021 bonds at 80.77, which yielded the fund 5.35%. He then shorted the traditional bonds, also due in 2021, at a price of 93.88, which required him to annually pay out 5.66%. This generated a negative carry yield of 31 basis points.

The pair trade hedged out credit, interest-rate and capital risk.  If a ratings downgrade were to cause Italian bond yields to soar and prices to fall, Barnegat’s position would be virtually neutral.

To hedge inflation risk, Treue employed European Inflation Rate Swaps that are based on the same inflation-rate index as Italian bonds. This arrangement essentially made the two bonds the same. And since the swap’s fixed rate was higher than the inflation rate he had to pay, the exposure netted him 2.31%. Deducting his carry loss, Treue established a trade that paid him an annual rate of 2 percentage points—a yield he’s happy to sit and collect while waiting for the inflation-protected bonds to rise and the nominal sovereign to fall.

Because Barnegat employs substantial leverage in executing this arbitrage, the yield is significantly boosted. The trade represents half the fund’s net asset value and has contributed 8% to the fund’s returns.

Foreign exchange risk was also taken off the table because the impact of any currency move on Treue’s short-term repo financing costs would inversely alter the value of the bonds. Simply put, if the euro gets stronger and requires higher payments to fund the trade, the value of the bonds in dollar terms appreciates accordingly.

While the deep, liquid and well-followed Italian bond market increases the likelihood that the trade will work, Treue says there are two basic risks—one predictable and avoidable and the other extremely unlikely. “If the interest rate spread widens, then we would be required to meet margin calls,” explains Treue. He plans for such a possibility by keeping half of his assets in unencumbered cash.

If the repo market—the means in which he borrows and shorts bonds—sees a significant reduction in liquidity (a likely sign that all markets are in big trouble, as in 2008), Barnegat could end up paying a net carry yield. And if such negative conditions persist, Barnegat could be forced to liquidate the trade at a material loss.

Fixed-income arbitrage, or relative value, trades must target securities that are sufficiently comparable and in deep liquid markets to ensure the market will correct the price differential.

Fund managers also need to show patience and experience in deciding when the differential is wide enough to generate a return that’s worth the risk and time. They must be able to sense when the mispricing is nearing its peak. Often, the difference in performance between fixed-income arbitrage managers is not necessarily their ability to spot special opportunities, but their ability to time their investments.

There is no overstating the critical need to maintain healthy cash balances to meet margin calls, especially in today’s environment, where interest rate creep is expected. The implosion of Long-Term Capital Management in 1998 wasn’t the result of poor investment. In fact, the fund’s venerable brain trust had it right. They simply didn’t keep enough cash on hand to keep the trade funded when it moved sharply but temporarily against the fund.

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