FI Arb

Hi, wanted more color on fixed income arbitrage as a career in this environment. Have only traded money markets for under a year, trying to figure out how far I should pursue this aspect of RV. Thanks in advance.

In UST cash space, what are some bottoms up implementation approaches? Seems a lot of it involves trading around Fed open mkt operations in specific sector, i.e. buy the issues Fed most likely to buy, short the others. I'd imagine most guys look at a spline curve, spreads on historical basis, breakdown in correlation/vol to narrow down guesswork. How about the classic buy olds short on-the-run trades though the auction cycle? Here it seems the main considerations are the financing cost of the on-the-run issue and the fact that these are probably the most over-crowded trades.

Also, what's the macro backdrop of these trades? Outside of hedges to protect against major dislocations to bond markets, does one really overlay a macro viewpoint to these short horizon trades which seem to involve a lot of leverage to eke out handful of bps. Is it right to claim that this is the area of 'macro RV' where knowledge of flows adds value most directly since structurally you're looking for small moves.

Finally, do tsys futures play less of a direct role in these trades nowadays, given their low optionality in this rate environment? I kinda remember reading the first chapter or so of the bond basis book, almost of of the illustrations seem predicated on a non-zero short rate environment (where the CTD actually shifts).

*EDIT* Understand this may comes off as a very narrow view of FI Arb; focused on UST cash for simplicity. Would be happy to hear wider perspectives in this arena.

 
Best Response

My Z$2c... Also note that the more specific elements below will vary depending on the particular context.

There is only one fundamental bottom up approach in bond RV. Simply, you buy cheap bonds vs selling expensive bonds (the latter is much trickier, generally). Strategies which involve the Fed are a lot less interesting and viable now and I don't know many people who actually look at that a lot these days. And yes, the ways of determining which bonds are cheap and rich will involve all those things you have mentioned. As to the old "short currents, buy olds or double olds or whatever", there's all sorts of evidence to suggest that it wasn't really ever a money-making strategy in the first place (repos kill it).

As to your second set of questions, whether or not one needs a macro view/hedge depends on the specifics of the trade. If it's "micro bond RV", a macro view is probably overkill, especially if it's a short-term trade. As to "knowledge of flows", I don't think that's the term I'd use. Understanding broad patterns of behavior of different investor types and how they interact is more like it and that's useful in any context, including RV.

Bond futures are always going to play a front-and-centre role, regardless of switch etc optionality. The trades arnd the futures are much more about liquidity/balance sheet dislocations than the traditional, old-school basis.

 

just wondering...for those of you that do this RV stuff, do you spend most of your day watching over all these instruments and manually looking for trade opportunities? or have you automated to the point where a notification pops up if there's a trade to be done, and you spend most of your day refining the algos and decision rules?

 

US treasury fixed income relative value is for the most part gone today or at least is in hibernation until ZIRP forever is gone and until funds can again lever up to the insane levels necessary to make exploiting very small abnormalities profitable. I have some experience working at a fund that did this as a primary business and it definitely feels like a different era when things like match book repo trading were profitable and guys could lever up 100-1 without even a blink of an eye from banks.

 

@Bondarb --I work on repo side and I cant underatand when you say amntch book repo used to be profitable. For me match book rpeo is an interest rate swqap. You get collateral in and earn a rate, you send it out and pay a rate. Net net you have an interest rate swap and you can be long or short duration too depending on the legs. hence it should be as profitabel as a swaps desk (in theory).. though more balance sheet i understand..

pls would liove to hear things about the old day, given that they ar enot coming back anytime soon

 

I think Bondarb was simply suggesting that relative to pre-2008 financial crisis (before fed funds was cut to 0-25 bps), repo profitability has gone down a lot. This should be pretty clear, by cutting short-term rates to 0, the 0-2y curve has been at historical lows and flat - reducing front end spreads. Before the crisis, you might have had overnight treasury GC at 5%, and various specific treasury issues trading between 0 to 5%, so making 100-200 bps spread on an off-the-run issue overnight was probably not uncommon. Moreover, there was a front-end curve you could actually roll down because the Fed was cutting/hiking Fed Funds. Let's breakdown the current environment.

Nowadays, the treasury GC curve looks something like this: o/n- 1wk: 06 / 05 bps 1wk - 1 month: 07 / 06 1 month - 3 month: 08/07 4 months: 09/08 5 months: 10 / 09 ... you get the idea

So what can you do with GC? Well you can take in collateral on term for 3 months at 8 bps, then fund it through tri-party GCF at 5 bps overnight. Money market funds aren't too willing to take collateral under 5 bps, because they can go to the Fed's o/n repo facility and earn 5 bps risk-free. That earns you a shitty 3 bps for 3 months, minus fees.

You can fund specific treasury issues, but most off-the-run "specials" trade 5 bps thru GC, so that's marginally better. You can trade on-the-run specials, but even most of these issues don't get that tight anymore. And yeah it eats up a lot of balance sheet, which makes it a target for elimination due to increased regulation.

In spite of all this, it's still possible to be profitable trading matched book nowadays. Having a good sales force and being aggressive in using resources to make spreads is key. Having a good specials trader helps too. But ZIRP killed quite a bit of the upside. Still understanding the Treasury function and the front-end is pretty invaluable if plan on trading other stuff in the future.

Or you could just skip all this if you have access to IOER (though you might get about 1.5 years out of it if you're lucky).

 

its pretty simple...back in the pre-ZIRP days funding on issues could fluctuate between 6% and 0% throughout the course of the day and guys used to trade that just to speculate rather then to fund a cash position...this was generally called the repo desks "match book". It was a very wild west market and guys would squeeze issues every day creating these large swings...obviously for an RV fund these swings would seriously impact the forwards and the profitability of their positions depending on their funding decisions. Nowadays repo markets have very little volatility, banks will not use balance sheet for this type of trading, and the regulators have gotten rid of all the market manipulation that used to go on.

 

Actually there still are still plenty of speculators in the repo market now. Sure, most of the special issues are confined to the on-the-run govies, but for these issues all that's really different is that 6% to 0% has been replaced with 0% to -3% as fail charge is imposed. Last year was not a great year for govie market makers, but a good repo desk would've taken advantage of the opportunities created by bearish market and debt crisis. It probably will die soon, but hard to imagine dealers completely cut from specific issues market.

Finally, was it really that bad in the "wild west" days? Okay Salomon seems guilty, what about the rest of the street? Everyone from Central Banks to PIMCO seems to have been implicated in tsys squeezes, so who's the say the short base is deliberately due to dealers? According to Burghardt's book Japanese investors didn't even start doing repos till after the 80s. Seems the CNN article is a bit disingenuous in that the dude who is claiming foreign investors would flee from govies due to repo blow-up doesn't seem to realize they are part of the problem from time to time.

 

Well I do not know much about the space, but I would say it's been challenging if yields have been compressed. Right now, the bond market in the energy space is fairly dislocated which may bring some interesting opportunities.

I'm assuming a lot of these funds are trading-focused so probably a trading background would be ideal. I'm assuming an investment banker wouldn't be good at yield curve trading but better suited for a L/S equity.

 

Asked something similar awhile back, got some pretty good color.

Strategies/trades run the whole fixed-income gamut. Many focus on liquid strategies in G3 - G7 markets. Trades include yield curve steepeners/flatteners (aside from a few tactical plays, the former have been spanked), swap spreads and invoice spreads, spread of swap spreads, rates vol. Also see quite a few plays in the front-end curves, including basis swaps and other ways of taking view on short-term rates. Some also focus on inflation. Can only speak for short-rate trades I've put on but much of what I've seen has been motivated by technical factors with a macro overlay.

People still do stuff within a particular sector of the Treasury yield curve as well, but impression is this is getting thinner and thinner. Auction cycle plays with on-the-run vs. off-the-run trades are viable to the extent you can predict repo rates, which is something one can do fairly well sitting on a repo desk all day, though may be difficult elsewhere. Treasury futures arb for the most part is trickier, optionality has ticked up somewhat but remains quite low by historical standards. Outside of CTD, it's gonna get illiquid. The long-end of the curve is pretty illiquid, off-the-runs generally are quite illiquid.

Backgrounds vary, but of the ones I'm familiar with, most come from fixed-income market making or bank prop desks (many from JPM it seems) with technical backgrounds.

Not sure about overcrowded, though there seems to be pretty high barriers to entry. Wind down of prop desks means less competitors, but also more suspect liquidity in certain parts of curve. It also makes it difficult to find a job to the extent the good guys with experience are gonna be snatched up. Many strategies rely on a firm macro understanding, so getting the macro picture wrong probably means underperformance.

 

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