Not Another Investment Podcast
Understand investing beyond the headlines with Edward Finley, sometime Professor of Finance at the University of Virginia and veteran Wall Street investor.
Not Another Investment Podcast
Exploring the Hidden Tactics of Hedge Fund Arbitrage: Convertible Arbitrage and Fixed Income Arbitrage (S1 E16)
Uncover the opaque world of hedge fund arbitrage strategies where the stakes are high, and the strategies complex. I'm Edward Finley, your guide through the maze of these strategies that seek to earn return by uncovering mispricing of risks but really do so by taking on much more hard-to-understand risks.
In this episode, we'll start with the two main bond arbitrage strategies: convertible arbitrage and fixed income arbitrage. We'll discover the role of convertible arbitrage in providing liquidity to the very important convertible bond market. Learn why certain companies lean towards issuing convertible bonds in the first place, and how important convertible arbitrage strategies are in making this market function well. But gain an understanding of what risks investors take in providing that liquidity.
Then join me as we explore the two primary fixed income arbitrage strategies: interest rate arbitrages and credit arbitrages. Learn about the two most common interest rate arbitrages that focus on preferences of bond investors and peculiarities in how Treasury futures settle to create opportunities for investors. And uncover the three typical credit arbitrage strategies and their approach to earning returns when markets misprice a firm's risks. And in both cases, observe with me the complexities of owning these kinds of risks.
In the next episode, we'll close-out hedge fund arbitrage strategies by exploring the equity-focused arbitrage strategies: merger arbitrage, distressed investing, and event-driven arbitrage.
Join us as we embark on this exciting expedition into the hedge funds' arbitrage playbook and their ripple effects across the financial markets.
Episode Slides: https://1drv.ms/p/s!AqjfuX3WVgp8ukUSIvQvpsQ8WjaM
Thanks for listening! Please be sure to review the podcast or send your comments to me by email at info@not-another-investment-podcast.com. And tell your friends!
Hi, I'm Edward Finley, a Sum-Time Professor at the University of Virginia and a Veteran Wall Street Investor, and you're listening to Not Another Investment Podcast. Here we explore topics and markets and investing that every educated person should understand to be a good citizen. Welcome to the podcast. I'm Edward Finley. Well, last time we undertook to investigate the second category of hedge funds, namely absolute return strategies, where we saw an attempt by managers to strip out all of the common risks, leaving them just with strategies that are in returns for the non-normal or asymmetric risks that are created by their trades. Today, we then take up the last category of hedge fund strategies, namely arbitrage. What exactly is the unifying theme among arbitrage strategies? Generally, these strategies operate in markets or with securities where the pricing of risk is very challenging. Sometimes that's for behavioral reasons, sometimes it's due to complexity, sometimes it's due to uncertainty, but it can be all of the above. The net effect is that that difficulty in pricing risk leads to an opportunity to own only the non-directional risk, that is, the mispricing itself, and earn positive returns for that. There are five strategies whose risk profile puts them in this category convertible arbitrage, fixed-income arbitrage, merger arbitrage, distressed and event-driven arbitrage Just again to give you a high level arbitrage strategies are the second largest hedge fund category. Dynamic market is the largest, at about $2 trillion, and arbitrage strategies are behind it at about $1.4 trillion. If we break up the arbitrage strategies those five that I just mentioned the largest by far is fixed-income arbitrage, that's about $900 billion altogether. The second largest is event-driven, at $240 billion. Then comes a sort of distant third merger arbitrage with about $90 billion, and then the two tiny ones of convertible arbitrage at $37 billion and distressed securities at around $16 billion. When we think about these categories, strangely I'm going to take one of the small ones first and I'm going to take up convertible arbitrage first. The reason is simple. It's the first of any of the hedge fund strategies we've discussed where there is some purpose for the strategy that's not related directly to investors but has something to do with a greater market purpose. We'll talk about convertible arbitrage first in this episode and then, second, fixed-income arbitrage, both of which we can think of as kind of quote bond strategies. Then in the next episode, we'll continue arbitrage with the remaining three equity strategies Without further ado.
Speaker 1:Convertible arbitrage Generally speaking, what these strategies do, which is sort of very unique for the hedge fund space is they play a key role in providing liquidity to the convertible bond market by doing that to companies that borrow on the convertible bond market. Some estimates tell us that convertible arbitrage hedge funds own about 30% of all outstanding convertible bonds. Well, you might be asking what's a convertible bond and why do I care? Convertible bonds are hybrid securities. They're a bond just like any other bond issued by a corporate. So that means that they're credit risk. But these bonds are special in that the owner of that bond has the right to convert the bond into the equity of the company at a certain price. As a result, a convertible bond has really exposure to interest rate risk because it's a bond. It has exposure to option risk because we can think of that right to convert to equity as like an equity call option. It has exposure to equity risk because, at the end of the day, what you could potentially own is equity. Because, as we've said before, a corporate bond is really exposure to the company's equity risk. It's like selling a put to the equity owners of the firm. Given that the bond itself has an equity option embedded in it, it means that the pricing of these bonds can be very challenging If the pricing is done wrongly in the market, then arbitrageurs, like convertible arbitrage managers, can earn profit by doing that. But, as I say, there's a symbiotic relationship because the act of owning them in order to earn that arbitrage serves a very useful purpose other than just earning the arbitrage. It really facilitates the liquidity of the convertible bond market.
Speaker 1:Why do firms issue convertible bonds in the first place instead of just, say, borrowing from a bank or issuing a regular bond? Usually it's because there's a lower cost of financing. Most of the issuers of these bonds are not the highest quality rated companies. 86% of issuers are below A and you'll remember single A isn't even the top. Triple A is the top, then double A, single A is number three in the stacking order. 86% are below single A, 50% are between triple B and triple C and 23% of issuers aren't even rated. So the kind of firm that's going to issue convertible bonds is going to have to pay an extremely high rate of interest if they issue just an ordinary bond because their credit quality is so poor. But because the bond has an equity option embedded in it, it usually means that investors would be willing to accept a lower yield on the bond in return for that right to turn it into equity, and so, as a result, firms that are lower credit quality firms might choose to use convertible bonds, because it will just have a lower coupon rate that they have to pay. It's also possible that some firms might be perfectly healthy, highly rated companies, but they believe that their shares are currently underpriced, and so, rather than issue new equity and they don't feel they need more debt on their balance sheet, rather than issue new equity when their shares are currently underpriced, they might choose to issue a convertible bond.
Speaker 1:The valuation of convertible bonds is complex, primarily because there are only two principle methods by which you can value the embedded option in a convertible bond. One is by using option theory and the other is by using certain statistical models to tell us what we think the option is worth, but historically, neither of these methods has proven very accurate. As I mentioned a minute ago, as of the second quarter of 2023, convertible arbitrage hedge funds accounted for only about $37.6 billion in assets, which is a little less than 1% of all hedge fund strategies and is a tiny part of all arbitrage strategies. Well, what's the trading dynamic here? We've described a little bit about why managers buy these convertible bonds and what they think they're going to earn. How do they do the trading, which is going to give us some insights into the kinds of risks that we would own in owning this style.
Speaker 1:So earning returns for arbitraging the mispricing of the option in a convertible bond is going to really be the goal, but they're going to also want to make sure that they neutralize the equity exposure of the bond, because the manager is not looking to own equity risk. The basic trade is to buy the convertible bond, that is, to be long the convertible bond and short the stock. So far so good. Short the stock, because, if I own a bond which has both components, it has the bond component and it has the equity option component, and I short the stock. The theory is that I've neutralized the equity exposure by being short the stock, and then I just own the bond portion with the option part attached. Managers, though, can't just execute a trade like that on any old bond, for some highly technical reasons, so they look for very specific kinds of convertible bonds that have very specific qualities, both in terms of the bond itself and in terms of the underlying equity.
Speaker 1:In particular, managers are looking for convertible bonds with high convexity Now here. We've used that term before, but it's important to pause on it for just a minute to make sure it's clear. High convexity in convertible bonds means that there will be much higher changes in the bond price for a given increase in the underlying stock price. Then there will be changes in the bond price for a given decline in the price of the stock. So again, what you want are bonds that are trading in such a way that if there's an increase in the price of the stock into which you can convert it, the bond's price is going to go up quite a lot, and if there's a decline in the price of the stock into which it can be converted, the bond is going to go down less in price proportionately.
Speaker 1:The second kind of bond that they're looking for are those with so-called low conversion ratios. Conversion ratios just describe the ratio of the Price of the bond minus the share price of the underlying equity conversion rate. So that is to say, at what price can I convert into the equity? They want to find bonds that have low conversion ratios, where it minimizes the interest rate risk of the bond. They're also going to be looking for bonds of companies that stock has very low dividends. Why? Well, you'll remember, if the basic trade is to short the stock, they're going to want to make sure that the company's stock has very low dividends, because when they're short the stock they have to pay the dividend during the period of the short and that makes the carrying costs pretty substantial. And lastly, the manager is going to want to identify those underlying stocks that are more volatile than the bond itself. If the underlying stock is more volatile than the bond itself, chances are they're going to be able to really focus on the mispricing of the option part.
Speaker 1:So a manager that's looking for these very specific kinds of bonds is going to need to account for a few things. They're going to need to account for the convexity risk, that is, this difference in the change in the bond's price for a given change in the underlying stock. They're going to need to account for interest rate risk. They don't want to have exposure to the risk that the Fed changes monetary policy and rates go up and down. And they're going to have to account for credit risk, because they really don't want to own the credit risk of the firm. They're just trying to capitalize on the mispricing of that firm risk. So managers can pretty easily hedge the interest rate risk and can pretty easily hedge the firm risk. We can do that with either an interest rate swap or a credit default swap on the firm. But in order for them to hedge out the option risk, that is to say this convexity risk, it's a little more complicated, and so managers have to adopt trading strategies that are sometimes known affectionately as the Greeks and you'll see why they're called the Greeks.
Speaker 1:They will often have to do something called delta hedging, which accounts for the changing sensitivity of the bond price to changes in the price of the underlying stock. They're looking for those with high convexity, but of course it's not static. That changing that sensitivity will change over time. So delta hedging helps protect them against that risk. Vega hedging accounts for the changes in the volatility of the underlying stock. They're looking for very volatile underlying stocks, but that will also change over time. So they might use Vega hedging in order to account for that risk. Theta hedging is something they can do to account for the decay of the option portion of the convertible bonds price. All that means is, as you get closer and closer to the date at which you can exercise your option, its value gets smaller and smaller, and so it's decaying, and so they can do something called theta hedging in order to hedge out that risk. And lastly, they can engage in something called gamma hedging or gamma trading in order to earn short-term profits in responses to any changes in their delta hedges.
Speaker 1:If you didn't follow all of that, it's okay. What you need to take away is that it's a very complicated style of trading. It introduces massive numbers of asymmetric, nonlinear trades that are going to have a really important impact on the returns of the strategy. The Greeks is how we shorthand that. Okay.
Speaker 1:So what would we expect to see here? Well, we would expect to see that, because you are really trying to sort of extract a premium from the mispricing of this option, that means you're trying to extract the mispricing of the firm, and so that means we should expect to see some directionality with equity risk, but of course, the manager is trying to keep that to a minimum and trying to keep the other elements to a minimum. So while we'll see some directionality, it shouldn't be terribly strong. We also would expect to see that the managers are going to have a fairly significant exposure to these alternative risks. We would expect to see really strong nonnormality, really strong nonlinearity in the manager's return streams and that's going to show itself up in its data. And lastly, we would probably expect to see a fair bit of volatility and we would probably expect to see a fair bit of illiquidity in the strategy. Remember, these are lower credit quality firms and their trades are highly structured and highly technical and that means if there's any kind of market distress, maybe that has nothing to do with the firm itself or its convertible bonds. Nevertheless, that might really create illiquidity in the market for these securities.
Speaker 1:All right, let's take a look at the aggregate data and see if it bears out what we would expect based on its trading strategies. So first, the regression results. Interestingly, the regression results tell us that the common risks explain a fair bit of the returns of the strategy about 58% of the strategy's returns. So, unlike what we saw earlier in the absolute return strategies, where really the linear regression told us that the common risk factors explained very, very little of the returns, this is a bit more like what we saw in the dynamic market strategies, where the common risk factors explain a fair bit, just not all Only 58% of the strategy's returns. That tells us that there's still going to be drivers of return that are not captured by those factors.
Speaker 1:The correlation with interest rates and credit and high yield risk are the main drivers here. In the linear regression, with investment grade risk there's a 64% correlation coefficient. With high yield, a 34% correlation coefficient. With treasuries, a 39% correlation coefficient. And, just to remind you, that just means for a 1% change in the returns of any of those risks. We would expect the strategy's returns to change by that percentage of 1%. So, for example, investment grade bond returns increased by 1%, we would expect the convertible arbitrage strategies returns to increase by 64 basis points. So, meaningfully exposed to those risks.
Speaker 1:Equity risk is really not playing a role here at all. All right, let's turn our attention then to the summary statistics. The average annual return for the HFRI index of these strategies is 6.5%, with a volatility of about 9%, which gives us a pretty reasonable information ratio of 0.71. That's better than, say, the information ratio on US equities. That's better than the information ratio, say, for our 6040 portfolio. We see that equity correlation is pretty high 50%. But that shouldn't surprise us terribly because we saw that most of the linear risk exposures were for investment grade credit and high yield credit and you'll recall that those two exposures, both kinds of credit risk. Credit risk is really scaled equity risk, and so, not surprisingly, we see a pretty strong correlation with US equities. The beta for the strategy to US equities is much smaller, around 21% and this again reflects the alternative risk exposures that we have. We're earning returns for other risks that, in general, are causing volatility to be a poor measure of risk and that will make the beta seem lower than it might otherwise be. When we look at the correlation and betas to the tenure, they're very modest and they're negative, so essentially, really no connection there at all.
Speaker 1:When we look, though, for some evidence of this asymmetry and non-normality here, we get it in spades, and so, for example, there's a really large negative skew, almost a negative three. That's very, very large negative skew, and the kurtosis, the tail risk, is almost 27. Now recall, a kurtosis in equity markets is about two. That's non-normal, but it's not crazy non-normal. This is crazy non-normal, and if we just want to confirm, like we did in the last episode, well, we don't have a lot of observations. So maybe skew and kurtosis is not terribly reliable.
Speaker 1:We can look at the histogram and we can see that in the histogram there are massive tails, and they're mostly left tails, that is to say, mostly really bad, deep bad results in the strategy, and that makes some sense. These are very, very difficult strategies to execute. They involve lots and lots of trades that are non-normal and asymmetric, but they also express a lot of illiquidity when there are moments of distress, and so that is what we expect. We expect to see really massive left tails when markets take some tightness. We can also look at some examples of nonlinear risk. Here I'm gonna refer to something we haven't really talked to before because it hasn't been terribly relevant, but we can also compare the volatility of the strategy during up months that is, when the strategy is earning positive returns and the volatility of the strategy during down months, if the strategy is executing a fairly symmetric strategy. You'd expect to see that up-down volatility ratio be close to one. That is for whatever the volatility is on the upside, it's gonna look awfully similar on the downside, and that's what we saw why we didn't really mention it earlier in equity long short in macro. Likewise in the two absolute return strategies really pretty close to one, but here it's 0.46, and that means that the volatility on the downside is way higher, to the tune of 2X, than the volatility on the upside. So this is just more evidence of the non-linearity that we get with these strategies. That maybe the result of illiquidity, maybe the result of asymmetric payoffs, maybe the result of how very difficult it is to get the pricing right.
Speaker 1:The state dependent returns confirm exactly the same view. The state dependence returns show us that when we look at convertible ARB strategies relative to equities, we see some directionality. We can see that the worst monthly returns happen in the same quintile as the worst monthly returns for equities and the best quintile for equities. But when we look at the correlation of those returns we get again that smile shape. The correlation of the strategies returns to equities returns in the worst months is very high and it drives down to the third quintile and then starts to rise again in the fourth and fifth quintile, and so we see some pretty strong evidence of what's called negative convexity. When it's a smile rather than a hump, it's telling us that there's some evidence of negative convexity.
Speaker 1:We can also compare it, not to tenure treasury, because that's just interest rate risk, but here convertible ARB strategies are really dealing in high yield bonds, and so we would wanna just compare the state dependent returns to the state of the high yield bond market. And we see here again a very similar trend which is like the equity exposure, pretty much proportionally following, pretty much proportionally following the returns for the high yield bond market and evidencing the same negative convexity more modest than when we see it in the equities, but nevertheless it's there. And so a strategy like this that can earn 6.5% return for what seems like pretty modest volatility 9% volatility means that it is a strategy for which you're getting paid primarily for the really bad moments, the really really bad moments. And again back to the histogram it shows us that 138 of the monthly observations from 1997 to 2023, monthly observations are somewhere between zero and 1%. That's terrific, but when we look at the other monthly returns, we see that there's one month in which the returns were negative, between negative 15 and negative 16%. There was one month between negative 11 and negative 12. One month between negative seven and negative eight. Whereas if we look at the right side, we see that, yeah, there's one month in which the monthly return is between nine and 10% and two months between six and seven, but that's it. Then they start climbing back up to the kind of very small returns small monthly returns Some people call these kinds of strategies like picking up pennies in front of a steamroller, because the idea here is you regularly typically earn small but consistent, moderate returns that show very little commovement with equity risk or bond risk.
Speaker 1:But from time to time you experience terrible results, and that's an example of what we would expect to see with convertible arbitrage strategies. We're going to look at the next one and then we'll look at the next one. Okay, let's turn to the second of the arbitrage strategies that we'll discuss, the second bond strategy, the last of the bond strategies, and that's called fixed income arbitrage. Now, fixed income arbitrage, generally speaking, is a little different. Here these managers are looking to arbitrage the mispricings of firm risk the mispricings of firm risk, except not in the way we saw convertible arbitrage managers trying to arbitrage mispricings of firm risk, ie not through the mispricing of this embedded option. Instead, what these managers are looking to do is they're looking to earn return with little or no correlation to interest rate risk, but merely some relationship about how the bonds pricing of firm risk is off. Generally, they look for bonds that statistically or historically have been very closely correlated. They have similar risks, very closely correlated, but there's a divergence in price.
Speaker 1:For some reason, often managers exploit one or more structural anomalies in fixed income securities, or they exploit the effects of segmentation in different types of credit risks in order to find opportunities. Those two things that I just said both the historic or statistical correlation between bonds and the structural anomalies and segmentation sounds opaque, but I'm gonna give you examples in a minute that I think will make it more clear. The mispricing in these bonds, however, is generally very small, and so, in order to make reasonable returns for their investors, these managers use a lot of leverage. As of the third quarter in 2023, fixed income arbitrage amounted to nearly a trillion dollars in assets under management. That's about 19% of all hedge fund strategies, so it's not only the biggest part of arbitrage strategies, it's a pretty reasonably big part of all hedge fund strategies, sort of right behind equity long short.
Speaker 1:There are two main ways in which fixed income arbitrage managers try to exploit this mispricing in credit risk. One is an interest rate arbitrage and the other is a credit arbitrage. So let's take them up in turn. First, the interest rate arbitrage. The interest rate arbitrage really comes in three flavors. The first is a pretty just straight up difference in when the bond was issued. These managers take advantage of the fact that newly issued bonds, which are called off the run, tend to be preferred by investors to previously issued bonds called on the run, even if the bond has the same maturity and the same duration. So there are two bonds issued by the same company with the same maturity and the same duration, but one of them was issued last year and has 10 years of remaining maturity, and the other bond was issued today and has 10 years of remaining maturity. For reasons that no one really understands, investors tend to prefer the newly issued bond. What that does, of course, is it bids up its price and pushes down its yield, and so the manager is gonna wanna be long the older bond, the previously issued bond, and short the newly issued bond, because they expect that over a short period of time the market will figure out oh, we mispriced that newly issued bond because we're so exuberant about it and it will trade itself back to where it should be.
Speaker 1:The second flavor of the interest rate arbitrage is called futures basis arbitrage. This is a fancy title to really describe an anomaly in the way the treasury market works or prices futures contracts. So you remember, you can have a futures contract which promises the delivery of an asset sometime in the future, and that asset can be anything. And here we're talking about these futures contracts that promise the delivery of treasuries. And treasury futures are structured such that the seller of the future the person obliged to deliver the treasuries at some future date is not obliged to deliver a particular kind of treasury, but instead can deliver a mix of treasury bonds from a predetermined basket of different maturities, and they can pick whichever one they want. It's a little outside the scope of the discussion on this podcast. You might be wondering why in the world did they do that? The short answer is to enhance liquidity in the treasury market, but it's just the way it is.
Speaker 1:It's a very peculiar thing, but if I sell a futures contract to deliver treasuries, I don't sell a contract in which I promise to deliver a 10 year treasury with 10 year remaining maturity and a modified duration of 9.87 next February. Instead, I promise to deliver something like that, but I can choose from a predetermined basket of treasury bonds of differing maturities that average to what the promise is. So, for example, I can sell a five year contract on treasury futures and I can settle that five year contract with any bond having remaining maturity of at least four years and two months, and as many as five years and three months, and I get to pick. So I can pick whatever one and whatever mix I want, and they can be between four years and two months and five years and three months. Now, as I mentioned, it's designed to make sure that the futures market trades pretty close to the way the treasury market is trading. And these treasury futures trade 24-7, with lots of different kinds of buyers and sellers, which means there's almost constant price fluctuation, and the uncertainty about which of the securities will be cheaper therefore which one will the seller deliver to you creates the arbitrage, and so futures-bacious arbitrage is just a way of saying these are traders that are exploiting the uncertainty about which of the basket of treasuries will be delivered when a futures contract it comes matured.
Speaker 1:And the third flavor of interest rate arbitrage is a so-called swap spread arbitrage. All that this is doing is it's exploiting the fact that interest rates swaps don't on treasuries. Interest rate swaps don't always align with what treasury yields actually are, and so, as credit spreads widen and narrow, this creates an arbitrage for someone who is interested in taking advantage of the mispricing between what the actual spread is between a credit and a treasury and what the interest rate swap delivers. The second major type of fixed income arbitrage is the so-called credit arbitrage strategies, and there are really three primarily. The first is something called yield curve arbitrage. Now, here again, what we're arbitraging is the pricing of the firm per se.
Speaker 1:Yield curve arbitrage the managers take a view on some expected corporate financial results right, the expectation of what profits will be, or whether there's going to be growth in their underlying business or what have you and they predict what the slope of the yield curve for those bonds will be. Not the level right, because monetary policy sets the level of the yield curve, that's, the horizontal shifts up and down, just the slope the slope of the shortest maturity of that corporation's bonds and the longer maturity of that corporation's bonds. When managers expect events that will cause the yield curve to flatten, then they're gonna want a short, shorter maturity bonds and they're gonna wanna be long, longer maturity bonds. And if they expect events that will cause the yield curve to steepen, they're gonna wanna do the opposite. So they're gonna wanna be long the short end of the curve and short the long end of the curve. Now these managers can do this by executing trades on the bonds themselves. So they can be long and short the bonds. But remember, when you're short a bond you gotta pay the interest on the bond for as long as you're short and that cost that carry can really eat into profits. And you'll imagine that here, where the profit that you're trying to exploit is so small, that carry will completely swamp any profit that you've earned. So generally these managers don't go long and short the bonds and instead they use credit default swaps. So let me give you an example to kind of crystallize yield curve arbitrage for you.
Speaker 1:Back in 2004, fiat, which was its own company then, of course currently no longer Back in 2004, it seemed pretty unlikely that Fiat's bonds were gonna be upgraded. They were having some trouble with their business and their bonds had been downgraded previously and it seemed kind of unlikely in 2004 that they would be upgraded. It was more likely that they were gonna miss their revenue and profit targets in the next quarter. Stress of a corporate usually flattens the yield curve. So what's a manager in a credit arbitrage strategy gonna do? Well, the manager is going to buy the credit default swap on the Fiat five-year bonds and sell the credit default swap on the Fiat 10-year bonds and they're gonna size those trades to keep duration neutral. They don't wanna have exposure to duration risk. So that's a kind of classic example of what we're talking about when we talk about yield curve arbitrage.
Speaker 1:The second kind of credit arbitrage is a capital structure arbitrage. Remember Merton's model All securities issued by the same firm are options on the firm's assets. So it's the same risk, right? Doesn't matter if it's equity or a bond. Merton's model tells us they're all options on the firm's assets. If I own equities, that's really like owning a long call on the firm's assets with a strike price equal to the book value of its debt, cause I gotta pay the bondholders back. If I own a bond in the same company, it's like a short put. It's like I sell a put on the company's assets with the strike price equal to the book value of its debt.
Speaker 1:Options pricing creates, as we discussed a minute ago, a lot of uncertainty about the correct price of bonds and of the equity of the firm. If you think about the price of the equity and the price of the bonds as really being a function of these two different kinds of options, options pricing means that there's a lot of uncertainty about what the right price is and that creates arbitrage opportunities between the bonds and the equities of the same firm. More complex securities introduce even more uncertainty about the correct pricing. So bonds can have seniority or there could be contract rights. Shares can have be preference shares or not be preference shares. There can be special legal rights and bankruptcy. All of those things enhance the uncertainty between the correct price of the bond and the underlying equity. So managers in this strategy arbitrage that mispricing of the corporate risk using these different securities and they hedge out interest rate risk and they hedge out the firm specific risk.
Speaker 1:Last but not least, the third type of credit arbitrage strategy is something called long-short credit. It's also sometimes called credit pair trading. This is really in the high yield and riskier credit area of the bond market and you can imagine how this makes sense, as we discussed when we talked about bonds. High yield and riskier credit bonds really earn return predominantly for scaled equity risk and really very little for interest rate risk. And, as a result, if you're talking about bonds that trade and earn return primarily for scaled equity risk, couldn't I trade those bonds long and short, just like I would trade their stocks long and short. So think back to directional equity long short, where you're long and short because you're doing straight longs and shorts. You have a view on one stock is going to be worth more and the other stock is going to be worth less. Your views are independent of each other and you're long one and short the other.
Speaker 1:Or pair trading, where you're really looking at two securities that typically move in the same fashion and they've diverged. Well, that's really the same thing they're doing here, except in the world of high yield credit. They focus, therefore, on what are called crossover names. Those are companies that either just entered a period of distress or just exited a period of distress. So at those junctures, those crossovers, it's notoriously difficult to price what the firm risk is, partly because of uncertainty but partly just because of human behavior. And so managers develop very sophisticated models to evaluate firm risk of a crossover name and identify whether the market is pricing that risk correctly or not. In addition, macro factors, economic factors, can affect the spread between different companies' securities in the same industry and create a kind of arbitrage, and so managers in these strategies keep some amount of credit exposure, just like in equity long short, they keep some amount of equity exposure, kind of depending on the macro environment.
Speaker 1:Do I want to own more credit exposure or less? So this looks and sounds a lot like equity long short. Indeed, it should in that sense, but they're trading in high yield bonds instead. There are lots and lots of other fixed income arbitrage strategies trading inflation with tips, trading bonds with the same company in different currencies, structured finance this goes on and on. That's why it's such a big part.
Speaker 1:But in the aggregate, what do we expect to see? Well, in the aggregate, we expect to see that, again, these are going to be trades in which we have a lot of leverage, which will mean lots more tail risk, non-normality. We expect that there are going to be very, very complex and difficult computations, so we would expect there to be price differentials when there's market stress. That's going to really negatively affect what we do. We're going to expect that this is a strategy where, sure, you own a fair bit of directional common risk factors no two ways about it. But that's not going to explain all the returns You're earning returns for these other non-normal risks. So let's have a look and see what the aggregate data tell us.
Speaker 1:Starting with the regression results, we see that the common risks here explain a fair bit of the variation in returns. About 63% of the strategies returns are explained by the common factors but there are still about 2% of the annual returns that are not captured by those factors. The most important linear factors that we see present in the strategy are going to be credit and high yield and interest rates, not really equity risk. Again, that makes perfect sense because the kind of equity risk you own is scaled equity risk and that's already going to be in investment grade bonds or in high yield bonds, so that sort of works. It makes perfect sense as well.
Speaker 1:When we look at the summary statistics, on average these strategies earned 5% return with 7.5% volatility, giving a modestly better information ratio than equities of 0.67. We see the kind of expected higher correlation to US equities, around 61%, but lower beta, again telling us that there's a directional relationship to equity risk. But the non-normal risks are causing the volatility of these securities to be lower than the market's volatility overall. We also can look at the correlation with the tenure and beta. To the tenure they're modestly negative. So really these have stripped out most of the interest rate risk in their trades.
Speaker 1:But when we get into the non-normal risk. Here again, just like with the convertible arbitrage strategy, we see the non-normality in spades. So we have skew of negative 2.5. That's a massive negative skew. We have kurtosis of 14. And, just like with convertible arbitrage, we want to double check ourselves here to make sure that we're not getting a false read on skew and kurtosis. So we can look at the histogram and we see a very, very similar distribution. All the majority of the returns are centered around monthly returns that are between zero and 1% a month. But then on the left side we see two months where the returns were negative 10 to 11%. We see one month negative seven to negative eight, et cetera. But on the right side, only three returns are between four and 5% and those are the highest monthly returns we see. So it's the same idea that these arbitrage strategies really are delivering on these alternative risks, but these alternative risks are principally tail risks, and that's partly due to leverage and partly due to illiquidity.
Speaker 1:Turning our attention then to the state dependent returns, we can look, compare to US equities. We can also compare to high yield because, just like convertible arbitrage, these managers tend to work just in that space and we see very, very similar results. We see that there's a kind of collared relationship. In both cases the strategies worst monthly returns occur during the periods in which equities or high yield had the worst monthly returns, best monthly returns in the period where high yield and equities had the best monthly returns. But when we look at the correlations and the participation, we see negative convexity. That's that U shaped relationship where we find that the worst months and the best months have higher participation and higher correlation, and that is really a feature of how these trades are built. And so that's really all I have for the first two of our arbitrage strategies. In the next episode we'll come back and finish the arbitrage category with the three arbitrage strategies, namely merger arbitrage, distressed and event driven. Thanks again for listening and I look forward to talking to you next time. You, you, you, you, you you.
.jpeg)