Credit Spread Arbitrage
Credit spread arbitrage is a trading strategy used in the fixed-income and derivatives markets, where a trader look to profit from the difference (spread) between two credit instruments.
The strategy involves simultaneously buying and selling related securities to exploit price inefficiencies and differences in credit spreads.
True credit spread arbitrage is trading price discrepancies between equivalent securities. However, the term often is most used to refer to a relative value credit strategy.
Key Takeaways – Credit Spread Arbitrage
- Profit from Mispricing
- Credit spread arbitrage exploits price discrepancies between related credit securities.
- Risk Management
- Effective hedging is important. Traders must balance long and short positions to reduce risks associated with credit events and market volatility.
- Market Insight
- Success requires deep understanding of credit markets, issuer fundamentals, and the macroeconomic factors that influence credit spreads.
Key Concepts
Credit Spread
The credit spread is the difference in yield between two bonds of similar maturity but different credit quality.
It reflects the additional yield a trader/investor demands for taking on the additional risk associated with a lower credit quality bond.
Arbitrage
Arbitrage is the practice of taking advantage of price differences between two or more markets to generate a profit.
In credit spread arbitrage, this involves trading on the spread between different credit instruments.
How Credit Spread Arbitrage Works
Identifying Opportunities
Traders identify opportunities for credit spread arbitrage by analyzing the spreads between different credit instruments.
These can include:
- corporate bonds
- credit default swaps (CDS), or
- other fixed-income securities
The goal is to find instances where the spread is mispriced or expected to change in the future.
Constructing the Trade
Once an opportunity is identified, the trader constructs a trade by simultaneously going long (buying) one credit instrument and short (selling) another.
The choice of instruments depends on the specific strategy and the expected movement of the spreads.
Long Position
In a long position, the trader buys a security that is expected to increase in value or where the yield is expected to decrease.
This could be a higher-quality bond or a CDS with a lower spread.
Short Position
In a short position, the trader sells a security that is expected to decrease in value or where the yield is expected to increase.
So, this could be a lower-quality bond or CDS with a higher spread.
Credit Spread Arbitrage Example Trade
Let’s walk through a specific example of a credit spread arbitrage trade, step by step, with exact amounts.
Step 1: Identifying the Opportunity
Let’s say a trader identifies a mispricing between two corporate bonds issued by different companies within the same industry.
- Bond A = A high-quality bond from Company A, rated AA, with a yield of 3%.
- Bond B = A lower-quality bond from Company B, rated BBB, with a yield of 5%.
The trader expects the spread between these bonds (currently 2%) to narrow to 1.5% due to anticipated improvements in Company B’s creditworthiness (e.g., an upgrade from one or more major rating agencies).
Step 2: Constructing the Trade
To exploit this opportunity, the trader will:
- Go Long on Bond B: Buy $1,000,000 worth of Bond B.
- Go Short on Bond A: Short sell $1,000,000 worth of Bond A.
(These are example amounts. The trader can buy/sell from whatever the minimum amount is.)
Step 3: Executing the Trade
Long Position on Bond B
- Buy Bond B: Purchase $1,000,000 worth of Bond B with a 5% yield.
- Annual Coupon Payment: $1,000,000 * 5% = $50,000.
Short Position on Bond A
- Sell Bond A: Short sell $1,000,000 worth of Bond A with a 3% yield.
- Annual Borrowing Cost: $1,000,000 * 3% = $30,000 (cost to pay the coupons to the bond lender).
Step 4: Holding the Position
Income from Bond B
- Coupon Payment Received: $50,000 annually from Bond B.
Costs for Short Position on Bond A
- Coupon Payment Paid: $30,000 annually for Bond A.
Net Income
- Net Annual Income: $50,000 (received) – $30,000 (paid) = $20,000.
Step 5: Expected Outcome
After one year, suppose the spread narrows to 1.5%, and the prices of the bonds adjust accordingly.
Price Adjustments
- Price of Bond A: Assume Bond A’s price decreases slightly due to a slight increase in yield (3.1% due to the spread adjustment).
- Price of Bond B: Assume Bond B’s price increases significantly as the yield drops to 4.6% due to the spread adjustment.
Selling Bond B
- New Yield of Bond B: 4.6%
- New Price of Bond B: Using the bond price formula, if the yield drops to 4.6%, the price increases. Suppose the price rises to $1,030,000.
Covering Short Position on Bond A
- New Yield of Bond A: 3.1%
- New Price of Bond A: If the yield rises slightly, the price drops. Suppose the price drops to $990,000.
Step 6: Closing the Trade
Selling Bond B
- Sell Bond B: $1,030,000
Covering Short Position on Bond A
- Buy Bond A to Cover Short: $990,000
Step 7: Calculating Profit
Capital Gains
- Profit from Bond B: $1,030,000 (sell) – $1,000,000 (buy) = $30,000
- Profit from Bond A: $1,000,000 (sell) – $990,000 (buy) = negative-$10,000
Net Annual Income
- Net Income: $20,000 (coupon payments)
Total Profit
- Total Profit: $30,000 (Bond B) – $10,000 (Bond A) + $20,000 (Net Income) = $40,000
Types of Credit Spread Arbitrage
Intra-Market Arbitrage
Intra-market arbitrage involves trading within the same market.
For example, a trader might buy and sell different corporate bonds within the same market to exploit spread differences.
Inter-Market Arbitrage
Inter-market arbitrage involves trading across different markets.
For instance, a trader might use CDS to hedge against corporate bonds.
This can take advantage of spread differences between the bond market and the CDS market.
Risks and Considerations
Credit Risk
Credit risk is the risk that the issuer of the bond or the counterparty in a CDS will default.
This risk is inherent in credit spread arbitrage, as the strategy involves dealing with different credit qualities.
Liquidity Risk
Liquidity risk is the risk that a trader will not be able to buy or sell a security at the desired price due to a lack of market participants.
This can impact the effectiveness of the arbitrage strategy.
Market Risk
Market risk refers to the overall risk of adverse price movements in the market.
Changes in interest rates, economic conditions, or market sentiment (i.e., flows and positioning) can affect credit spreads and impact the profitability of your arbitrage/relative value strategy.
FAQs – Credit Spread Arbitrage
What is pure credit spread arbitrage?
Pure credit spread arbitrage involves profiting from the mispricing between two very related credit instruments.
Traders take long and short positions in these instruments to exploit the spread difference, trying for a risk-free profit.
The strategy typically relies on identifying discrepancies in credit spreads that are expected to converge over time, regardless of overall market movements.
What are the differences between pure credit spread arbitrage and credit spread relative value?
Pure credit spread arbitrage focuses on the mispricing between two highly related credit instruments.
The strategy looks for risk-free profits by exploiting spread discrepancies.
Its goal is neutral market exposure, relying on the convergence of spreads over time.
Conversely, credit spread relative value involves evaluating the relative attractiveness of credit spreads across different issuers, sectors, or credit qualities.
This strategy may involve broader market views and can be influenced by, e.g., macroeconomic factors, credit quality assessments, and issuer-specific fundamentals.
Overall
Pure credit spread arbitrage is designed for minimal market risk.
Credit spread relative value strategies might accept more exposure to market movements and credit events – i.e., returns based on the relative performance of different credit securities.