Learn to invest with Buffett

Chapter 64

Chapter 10 Section 5 Fixed Income Arbitrage: Earning the Difference

Charlie and I have a simple view on derivatives and transactions: we will all see them as ticking time bombs, however for those interested in them and for the economy as a whole. Change hands, and the amount of change hands depends on other factors, such as interest rates, stock prices or exchange rate levels.

--Warren Buffett
In fact, Buffett is not so interested in investing in derivatives and leveraged investments, but it is not ruled out that he will involve in these areas by allocating fixed income arbitrage strategies.

In 1998 Buffett invested hundreds of millions of dollars through his hedge fund (run by Mark Byrne).Whether it is West End Capital Management or Mark Byrne's fund, they will focus on fixed income strategies. However, the difference is that Buffett is not only involved in fixed income arbitrage.

In the disaster of LTCM, the fixed income arbitrage sector in the fund suffered serious losses, but Buffett was willing to buy the assets of this company.Buffett found the company to be profitable, but was rejected in the end, which is why he would rather take the high leverage risk of fixed income.Buffett was involved in fixed income arbitrage even before the LTCM incident, when he became chairman of Salomon Brothers, and not long before a scandal erupted in their fixed income division involving a man for John Merry Trader who worked for John Meriwether, who later founded LTCM.

Fixed income arbitrage is not just one strategy, but a series of strategies through the process of buying and selling fixed income instruments, which can then be used to obtain a small gain, usually the difference in returns between two investments.

To use a very simple example, if a company has a corporate bond with a yield of 6% and a U.S. government note with a yield of 5% but the same maturity, then one can be long the corporate bond and short the government note , to get a 1% spread.Regardless of the risk of default for the time being, if the interest rate changes, there will be certain risks in the income of these two types of notes.If you are long a corporate bond and interest rates are trending upwards, the face value of the corporate bond will fall, if this hedge is done properly, to hedge the interest rate risk, hold corporate bonds by shorting government bonds , which would still result in a 1% spread in a relatively risk-free approach (assuming no risk of default on corporate notes).

Several main fixed income strategies are:
1. Bill spread transactions between governments and companies.

2. Gambling on the yield curve: If an investor is long on one part of the yield curve and short on another, then the rise of the yield curve will be a straightforward gamble.

3. Bill spread transactions between municipalities and governments.

4. For cash and futures trading, relative to the demand for actual bonds, when the demand for bond futures is sluggish, there will be room for development.

5. Spread trading between asset-backed securities (asset-backed securities) and other types of fixed-income instruments, an example of asset-backed securities are mortgage securities.In the fixed income arbitrage strategy, the risks that need to be hedged include: credit risk, interest rate risk, foreign exchange transaction risk and prepayment risk.

In this way, investors can see that the possible return of fixed-income arbitrage is very low, so a large number of leveraged transactions are widely used (10-25 times or more).When trading the spread between a bond and its futures contract, the spread can be tiny basis points (each basis point is [-]/[-]th).

Investment motto:

If investors use leverage ratios for fixed-income arbitrage, it is like vacuum coins that no one else can see. Fixed-income arbitrageurs will not take the risk of picking up those coins when there is a steamroller on their way.

(End of this chapter)