Fixed Income Arbitrage Strategy

The next group of hedge fund strategies are convergence trading or arbitrage strategies.  Fixed income arbitrage strategies is much like equity long/short.  The manager identifies cheap (undervalued) and expensive (overvalued) bonds and establishes long and short positions.  Returns are generated when they converge, the cheap position increases or the expensive position decreases.  Managers may use bonds such as US Treasuries, corporate, municipal and high yield bonds and mortgage backed securities.  Positions may be established at different maturity levels in the same bonds (yield curve arbitrage) or in different bonds that are similar.

Unlike equity long/short, the individual positions produce small returns.  Hedge funds that use this strategy use leverage to enhance returns.  This can be done by direct borrowing from their prime broker or using derivatives like swaps.

Most famous fund is Long Term Capital Management.  You can read a complete and concise account of the firm in When Genius Failed:  The Rise and Fall of Long-Term Capital Management by Roger Lowenstein.