Institutional Investor's Alpha Magazine - March 2008 - (Page 46) Strategies Fixed-Income Arbitrage Riding the imes are good — in some quarters. The yield curve has steepened, volatility has soared, and Mustafa Jama, chief investment officer at Morgan Stanley Alternative Investment Partners, a $12 billion fund of hedge funds, is happy to see it. For at least three years — through last summer — a fl at yield curve combined with record low volatility to leave slim pickings for hedge fund managers who look for relative value among fixed-income securities. But a sharp uptick in volatility and a suddenly steep yield curve — thanks to the aggresThe once-dismal sive easing by the Federal Reserve Board, which has arena of fixed-income pushed overnight interarbitrage is on the est rates down 225 basis points since last August rebound, thanks in part (and is expected to drop rates further this month) to the higher volatility — have revived relativevalue trades and other that accompanies a staples of fi xed-income arsteep yield curve and bitrage. As the yield curve steepens, managers not makes relative-value only have opportunities to exploit price anomalies trades profitable again. but can also expect them to move back into line faster. A steep curve also allows managers to borrow at low short-term rates to buy longer-dated bonds that pay a higher interest rate and then pocket the difference. “People have made tons of money as the yield curve has steepened,” says Jama, whose group is based in West Conshohocken, Pennsylvania. “They were long the two-year 46 • INSTITUTIONAL INVESTOR’S ALPHA • MARCH 2008 CURVE T By Neil O’Hara Treasury and short the ten-year.” He notes that both fixedincome arbitrage and macro managers have exploited a trade that may have further to go if the Fed continues to cut shortterm rates while inflation fears push long-term rates higher. For fi xed-income arbitrage managers, relief could not have come soon enough after investors deserted them in droves on the heels of disappointing returns in 2006. “Many fi xed-income arb managers either closed down or really sized down,” says Jama. “For the past three years, it was one of the most difficult places to be.” The fundamentals explain why. When the yield curve flattens, the classic carry trades — those that involve borrowing short to buy longer maturities — become less profitable and eventually uneconomic. Low volatility crimps margins on relative-value trades, too, because when prices aren’t moving much, they aren’t moving relative to one another, either. It’s a different story now. The Fed has sharply lowered its overnight lending rate since the fall — from 5.25 percent in September to 3 percent as of early February to inject liquidity into financial markets it says “remain under considerable stress.” That stress, of course, has brought the spike in volatility, which Jama says has breathed new life into relative-value trades. But he notes that prime brokers have clamped down on lending against mortgage-backed securities, a trend that has squeezed the margins in mortgage arbitrage. “The managers are scared of being flushed out of positions,” Jama explains. “They have brought down the leverage, and when you do that, the returns are not as attractive.” Not everyone is as enamored of fixed-income arbitrage as Jama, however. Stephen Vogt, chief investment officer at fund-of-hedge-funds manager Mesirow Advanced Strategies in Chicago, avoids the approach because its practitioners often use a lot of leverage, borrowing as much as 20
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