commodities trader here wanting to learn more about how a fixed income rv trade work
curious if anyone here can explain to a non macro trader here if how the mechanics of a bond rv trade work. is it analagous to a simultaneous long short trade equity market neutral trade where you are simply long and short a bond minimizing exposure to the market and betting on price convergence between the two? essentially this is a spread trade and non direction?
i always hear people saying it is balance sheet intensive, what does that mean exactly? where are these securities sitting on the balance sheet exactly?
Not too familiar. But my best guess is capital sheet intensive because hypothetically you have finance a large notional bond short position while simultaneously getting long exposure. Ie long 100,000 worth of a bond while financing a short position at 5+%. Would eat up minimum 105k plus margin?
Especially with short-end bonds the risk exposure vs cash you put down to enter a position can be skewed, i.e. for a 10k dv01 2y position, you use up ~$50mm for maybe ~$100k/day of PnL volatility (give or take) vs much lower cash outlay for a similar exposure in commodities or equities. Of course, you can use IR swaps instead and only have to put down margin payments but you offset by paying the o/n rate anyway.
The repo market solves the balance sheet intensive part since you can finance your bond position at around SOFR for GC by lending out your position and paying o/n on the cash. Without repo though you will tie up your balance sheet (the position lies on the asset side but has to be financed somehow, whether thru repo or more general liabilities.)
Thank you very much for the detailed example
Ah, a commodities trader looking to dive into the world of fixed income relative value (RV) trades, I see! Let's break it down, shall we?
Yes, you're on the right track. A bond RV trade is indeed similar to a long-short equity market neutral trade. You're essentially going long on one bond and short on another, betting on the price convergence between the two. This is indeed a spread trade and is non-directional. You're not betting on the market direction, but rather on the relative value between the two bonds.
Now, onto the "balance sheet intensive" part. This refers to the fact that these trades often require significant capital. The securities involved in these trades sit on the balance sheet as assets (when you're long) or liabilities (when you're short). The reason it's considered "intensive" is because these positions can tie up a lot of capital, which could impact the firm's leverage and liquidity.
Remember, while this strategy can be profitable, it's not without its risks. The resulting portfolio is likely to be quite leveraged and may not be as liquid as other strategies. But hey, no risk, no reward, right?
Hope this helps! Let me know if you have any other questions.
Sources: How to Make Money in The Market: Providing Liquidity, S&T vs Capital Markets Long-Term, Q&A Macro RV Analyst/Trader, Bulge Bracket Trading in Government Bonds
Sounds like a human wrote this but I’ll take it haha, ty
Re: your balance sheet questions, assuming its related to the basis trade everyone is writing about. In that case the pnl is small but due to repo you are able to lever it many times. The trade works because you will earn more on the price disparity than you pay on your financing. Banks will lend you cash versus your bonds as collateral, they will then lend those bonds to a money market fund and take cash, earning a spread. But since these two are different counterparties the risk can't be netted for regulatory purposes and their assets and liabilities are both higher, which can lead to higher costs. The CME has a lot of good info on bond basis.
Super helpful context thank you
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