Fixed Income Hedge Fund Strategies

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.


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 on maturity.

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.


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 higher yields.

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.


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 security.

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.