The European Central Bank’s moves to boost liquidity in the Eurozone are powering big returns for the high-stakes hedge fund strategy made notorious by the collapse of Long Term Capital Management more than a decade ago: relative value bond arbitrage.
Wide pricing anomalies in European bond markets caused by the ECB’s longer-term refinancing operation have led to bumper profits for a small group of arbitrage hedge funds in recent months.
While relative value bond arbitrage has been out of vogue since LTCM collapsed spectacularly in 1998, threatening to take down Wall Street with it, it has delivered big returns in recent years, outpacing almost every other hedge fund strategy.
Since the beginning of 2009, the average relative value arbitrage hedge fund has returned 45 per cent, compared with 31 per cent for their regular hedge fund peers, according to Hedge Fund Research.
“It’s a good environment for them to generate alpha [a measure of hedge fund managers’ skill-based returns] – because of the actions of central banks,” said Ermanno Dal Pont, head of Barclays’ European capital solutions business, which deals with hedge funds.
Italian bond markets, for example, exhibited unprecedented price discrepancies between different classes of bond issued by the government as a result of the ECB’s LTRO liquidity injection.
In January, investors dumped inflation-protected Italian bonds, fearful that they would automatically drop out of key European bond indices if the country’s credit rating was downgraded, while at the same time Italian banks snapped up regular Italian bonds with LTRO cash.
Hedge funds bought the cheap inflation-protected bonds, wrote swaps to offset inflation and then shorted expensive regular Italian bonds, thereby completely hedging out credit risk and inflation and locking in the supply and demand-driven difference between the two bonds.
The spread between them was more than 200 basis points, according to Bob Treue, the founder of Barnegat, a US-based fixed income arbitrage hedge fund that has made 18 per cent on its investments so far this year.
Other relative value arbitrage funds that have performed well include BlackRock’s Obsidian fund, which is up 13.5 per cent.
The spread in Italian bonds was “almost unheard of,” said Mr Treue. “There are very few arbitrages that top this.”
The “biggest arbitrage ever” was documented by academics at the US National Bureau of Economic Research in 2010, and involved a 250bp price discrepancy between US inflation protected and regular government bonds in the months following the collapse of Lehman Brothers.
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