Hedge Fund Investing Chapter 6: Fixed Income Relative Value and Credit Arbitrage

This chapter is about bond nerds. Specifically, hedge fund managers who make money by finding small price differences between bonds that should be priced the same (or very close). The strategies are called fixed income relative value and credit arbitrage. They sound boring. But the math behind them is wild.

The Core Idea

Here is the simplest way to think about it. Two bonds should cost roughly the same. But they don’t. Maybe supply and demand pushed one a bit higher. Maybe the market overreacted to some news. A hedge fund buys the cheap one and shorts the expensive one. When prices go back to normal, they pocket the difference.

This is “relative” value. The manager does not care if bonds go up or down overall. They care about the gap between two similar bonds closing.

Mirabile gives a clear example. A Treasury inflation-protected security (TIPS) might be trading cheap compared to a regular Treasury bond of the same maturity. The fund buys the cheap TIPS and shorts the expensive regular bond. If the gap closes, profit. If both bonds drop together, the losses on the long position get offset by gains on the short. That is the hedge part.

Two Flavors of the Strategy

The chapter splits these strategies into two buckets.

Fixed income relative value focuses on government bonds, interest rates, and currencies. These are the purest form. Managers look at historical relationships and bet that temporary imbalances will snap back. Common trades include yield curve bets (long-term rates vs short-term rates), cash vs futures arbitrage, and swap basis trades. Big macro firms like Moore Capital and Tudor Management have run these desks alongside their main operations.

Credit arbitrage is the other flavor. Here the focus is on corporate bonds, bank loans, and credit default swaps. Managers dig into specific companies and find pricing gaps within a company’s own capital structure. Maybe the senior debt is cheap relative to the subordinated debt. Or the commercial paper yields don’t match the long-term bond yields for the same issuer. The analysis is bottom-up and very company specific.

The Leverage Question

This is where it gets intense.

Fixed income relative value funds can leverage up to 10 to 100 times their assets. In practice, most use 10 to 20x. Think about that. A $100 million fund could have $10 billion in positions. The reason they can get away with this is that they trade government bonds, which have tiny margins (1 to 5 percent) because the credit risk is near zero. The trades themselves are small bets on small price differences. You need a lot of leverage to make meaningful returns.

Credit funds are more conservative. They typically leverage 3 to 4 times. Corporate bonds are riskier and less liquid, so brokers demand bigger margins. A $100 million credit fund might run $500 million in positions at most.

How the Firms Are Organized

A typical fixed income relative value firm has 10 to 15 people. Larger firms that trade mortgage-backed securities or international markets can have up to 100. They are organized around specialist desks. Government bonds desk. Mortgage desk. Each with its own team. They also have a dedicated repo desk because financing is such a huge part of the business. Most of the staff come straight from bank trading floors.

Credit funds are usually smaller. Around 10 to 12 people. Most of the team is focused on research and portfolio management. They carry fewer than 100 positions and know every single story in the book. These funds often lack scalability because they focus on narrow sectors. The CIO often does double duty as portfolio manager and head trader.

One interesting thing: credit fund managers need to know both bonds and equities. This is rare on Wall Street, where debt and equity divisions usually operate in separate silos.

Show Me the Numbers

Mirabile walks through two detailed examples.

For a fixed income relative value fund with $100 million, he shows three trades: a yield curve trade, a basis swap, and a cash vs futures carry trade. The gross leverage hits 33.95x. The fund produces a trading profit of $35.5 million and a net return of 9.13%. That is 6.13% above the risk-free rate. Not bad for trading government bonds.

For a $250 million credit fund, the leverage is much lower at 7.35x, but the trading profit hits $58.5 million. Net return: 10.36%. The net value added above the risk-free rate is 7.36%.

Both examples assume a standard 2 and 20 fee structure. After fees, investors still made solid returns.

Fund Terms

Fixed income relative value funds generally offer better liquidity than credit funds. Makes sense. The underlying government bonds are super liquid. Monthly redemptions are common for FI relative value. Credit funds usually go quarterly, semiannual, or even annual redemptions because their holdings are harder to sell quickly.

Minimum investment: around $2 million. Annualized target: LIBOR plus 5%. Target volatility: 7.5 to 10%.

Historical Performance and Growth

The sector grew from $150 billion in 2002 to $480 billion by end of 2007. Investors loved the stable returns in a low-rate environment. Hedge funds were delivering better yields than traditional bond funds, and institutional investors could understand the core products.

Then 2008 happened. These strategies got hit earlier than equities because they were exposed to mortgage-backed securities and asset-backed products that collapsed before stocks did. The real estate meltdown went straight through these portfolios.

But by 2011, AUM recovered to above $500 billion, exceeding the pre-crisis peak. At the time of writing, BlueCrest Capital (UK) managed the largest relative value fund at almost $9 billion. Other big names included Element Capital ($4 billion) and Brummer & Partners Nektar ($3.5 billion).

Risk and Return Profile

Looking at historical data for an established fund: annualized return of 13.54%, best month up 6.40%, worst month down 4.25%. Sharpe ratio of 2.03 is solid. Maximum drawdown was only negative 4.83%. Positive months: 79% of the time.

The strategy as a whole roughly matched S&P 500 returns but with less than half the volatility. The downside: it showed higher correlation to equity markets than you might expect. The bad years (2002, 2007, 2008) hit bonds and stocks at the same time, so the “uncorrelated” label didn’t hold up when it mattered most.

There is a famous academic paper about this strategy called “Nickels in Front of a Steamroller.” The title says it all. You make small consistent profits until one day the steamroller catches you.

Key Takeaways

• Fixed income relative value and credit arbitrage are about exploiting small price gaps between similar bonds
• FI relative value uses massive leverage (10-20x) on government bonds with very low margin requirements
• Credit arbitrage is more conservative (3-4x leverage) and focuses on corporate debt
• Both strategies delivered solid risk-adjusted returns historically but got crushed in 2008
• Manager selection matters enormously because the strategy label covers a huge range of actual approaches
• The risk is real: leverage amplifies losses, and when markets seize up, the “temporary” mispricing can get a lot worse before it gets better

Previous: Chapter 5 Part 2 | Next: Chapter 7

This is part of a series retelling of “Hedge Fund Investing” by Kevin R. Mirabile.