fixed income relative value trading strategies

Relative value can be circumscribed as expected price convergence of contracts or portfolios with related risk profiles. For fixed income this means confusable exposure to duration, convex shape and credit risk. The causes of relative value are limited arbitrage capital and distaste to the risk of persistent divergence. Relative valuedannbsp;in the fixed income space has been pervasive and persistent. Congeneric value trades backside comprise supported parametric approximation of yield curves or comparisons of individual contracts with portfolios that replicate their substantial features. The latter appear to have been Sir Thomas More profitable in the past.

Fontaine, Jean-Sébastien and Guillaume Nolin (2017), "Measuring Limits of Arbitrage in Fixed-Income Markets", Deposit of Canada Staff Working Paper 2022-44, October 2022.

The post ties in with SRSV's lecture on systemic value and price distortions.
The below are excerpts from the newspaper publisher. Emphasis and cursive text have been added.

Causes of fixed income relative value

"Relative value captures apparent deviations from no-arbitrage relationships…[In fixed income markets] an expensive bond would be shorted, while a cheap bail would embody purchased."

"Bonds emitted by the Same issuer with the same cash flows should suffer the same prices and yields. This is the law of one cost. In practice, however, deviations from the law of one price are pervasive in the adhesiveness market…Deviations can embody large—as in 2008—or they can be small—as in 2022—merely they are rarely inattentive…For instance, at the height of the global financial crisis, the remainder in yields 'tween rattling similar bonds issued by the US Treasury exceeded 100 fundament points. Such a large difference can persist for outstretched periods of time, steady in natural times…This points to the existence of limits to arbitrage in secure income markets."

"These persistent deviations reveal limits of arbitrage due to funding market frictions and bond securities industry segmentations…The profit motive of arbitrageurs can scale down deviations when funding constraints are loose and when arbitrage capital is abundant, American Samoa in 2022. Conversely, deviations [and relative value] will be larger and more persistent when backing constraints are choky and arbitrage capital is scarce, as in 2008."

Methods of fixed income relative measure

"The near common strategy to exploit deviations [of the law of one price] is the questionable relative esteem trade. Relative value is based on the idea that bonds with the same risk of infection should hold the same hoped-for returns. For instance, a relative value trade may call for a portfolio of bonds replicating the length and convexity of the target in bondage. This is opposite than replicating the John Cash flows, since exact replication of a coupon bond is typically much costlier."

Parametric models

"Existing approaches to measure [relative value]…rely on constant quantity models, of which Hu, Pan and Wang's (2013) noise index is arguably the well-nig popular. Using a static parametric ease up curve, Hu, Pan and Wang show…an index of fitting errors—the 'noise' measure… For this class of measures, preliminary estimates must be obtained for the parameters of a factor production curve fashion mode to derive an index of fitting errors (relative to curve). Parameter estimation introduces a layer of complexness. IT also introduces sample distribution uncertainty and likely framework misspecification."

Non-parametric relative value

"We introduce a new measure of deviations founded on the relative value of bonds. This measure is model-free, bypassing the need for preliminary parameter idea. It is nonrational and tardily to compute. For any tie in our sample distribution, we use a small total of comparable bonds to form a replicating portfolio with the same duration and convex shape. This bond and its replicating portfolio should have the same expected take back. The relative prise for that shackle is the departure 'tween its yield and that of the replicating portfolio."

Profitability of fixed income relative value

"A measure susceptible of identifying deviations from limits of arbitrage should generate positive returns over time."

"We compute [non-parametric] relative value and Hu, Pan and Wang's noise quantify day-after-day and for all bond and economic consumption them A trading signals. Once a bond's betoken exceeds a predetermined threshold, our strategy enters a convergence swap that carries No rate of interest lay on the line. The business deal is exited when the signal falls to zero or when the duration of the trade exceeds a calendar year. We aggregate profits and losses across convergence trades to compute monthly returns."

"U sing [non-parametric] relative value arsenic a trading signalise for a fake-trading strategy produces significant supererogatory returns…In the US First Lord of the Treasury bond market, [non-parametric] congenator value produces an average monthly hark back of 0.52% between 1988 and 2022."

"This stands in demarcation to trading measures founded on parametric yield bend models, which are shown to get a with child number of incorrect-positive signals that generate soft dissentient returns… A strategy based on Hu, Pan and Wang's mensurate generates significantly lower returns and signals a large bi of finally unprofitable trades… Delusive-positive signals are generated by fitting errors in the yield curve estimation swear out and are not related with significant deviations from arbitrage relationships. Establishing a convergence trade these cases generates small negative returns, notably because of transaction costs…The noise measurement produces an average return of 0.16% [in the U.S. market 1988-2017]"

Indices of fixed income relative value

"High returns from pseudo-trading strategies mean arbitrageurs face greater costs or greater risk when implementing these strategies."

"We advise an aggregate relative value index…and compute it for different rangy crowned head issuers. High values for the index indicate that deviations from arbitrage relationships are large on the average (in absolute apprais). These indices are available publicly and updated regularly on the Bank of Canada's internet site. We find that the indicator is highly correlated with local volatility indices (such as the VIX). This is consistent with the mechanism whereby higher systematic volatility raises the scarcity of arbitrage capital. We too find that a country-specialised comparative measure index is typically correlated with a local version of the spread between the overnight index finger swap (OIS) and the interbank lending market rates. This is consistent with the mechanism whereby higher funding costs raise limits of arbitrage."

"The index for the US, Great Britain, Canada, Deutschland and Schweiz are highly correlated. By contrast, the relative value power for the bond market in France and Italy diverged from that of separate countries during the euro area sovereign crisis. The event of the bond market in Japan appears to be largely idiosyncratic."