I am sure that by now you already know how to perform a fixed income arbitrage trade, since we have discussed this multiple times with examples like municipal bond arbitrage, convertible bonds arbitrage and most recently the liquidity based arbitrage trade in treasury bills. However, to ease everybody mind I am going to explain the plain vanilla way of bond arbitrage.
What are Bonds?
Bonds are also known as fixed income securities is one of the ways companies use to raise capital. Explain in a simpler way they are loans, nothing more than debt obligations. However, the key difference between income producing equities (divided paying stocks) and fixed income (bonds) is that bonds are senior to all other ownership structure inside the company. For example in a case of a bankruptcy bond holders get pay first, before the equity owners do.
What is Fixed Income Arbitrage?
The fixed income arbitrage strategy is the most simple of all bond arbitrage techniques since there is not a lot of moving pieces to it. You simply execute a simultaneous trade where you buy and sell bonds with similar debt structures intending only to profit from the difference between yields (the spread between coupons rates).
How to Arbitrage Bonds and/or Fixed Income
Now I am going to define you an even simpler approach in how to arbitrage bonds; a very useful tactic for this low interest rate environment. All you need to have is a portfolio margin account; and let’s say you do.
Imagine that the margin rates for your online broker are 1.5% and that you have $10,000 of buying power in your account. The only thing left to do is to find a high quality (AAA grade) government or corporate bond to buy with a higher yield than 1.5%. Because your straight-out profit would be the spread between yields presented by following equation:
Fixed Income Arbitrage Formula:
Total Return = Bonds Coupons Payments (Interest on Long bond)
– Transactions Costs (Margin & Leverage Cost)
+/- Capital Gain/Loss from Bond
Case Study Time
Develop an excel spreadsheet that can automatically calculate the expected total return of bond arbitrage position.
The Bottom Line
Under the right conditions, bond arbitrage can offer you riskless profits. The most important thing do is not to go too deep into the credit risk curve. Most of the time 50-100 bps of superior yield will suffice to realize a healthy profit.
When investing on bonds which rules inside the Arbitrageur Investing System do you follow the most?