Market inefficiency is a growing opportunity in fixed income

In a theoretically efficient fixed income market, closely related bonds (or derivatives) with similar risk characteristics would always be priced the same.1

In reality, these prices persistently diverge from each other, which means fixed income markets are inefficient.

This particular type of market inefficiency is what creates relative value (RV) mispricing, and is driven by underlying demand-supply imbalances that cause prices to temporarily deviate from fair value relationships.

Compared to equities, fixed income markets have a greater diversity of participants who are constantly buying and selling bonds (and related derivatives) for reasons other than profit maximization.

These are ‘non-economic’ market participants, and they have the following characteristics;

  • they are driven by different objectives and constraints that are independent of valuation
  • it is rational for them to transact at prices that deviate from fair value because they are not focused on maximizing profit
  • they are very large and their flows can dominate fixed income markets
  • examples include banks managing their balance sheets, governments financing budgets, passive investors tracking benchmarks and central banks pursuing policy objectives

Their activity creates disparate buying and selling flows that affect closely related securities in different ways, thereby creating temporary demand-supply imbalances.

This in turn causes those security prices to diverge even though they remain fundamentally linked and retain similar underlying risk characteristics, thus creating RV mispricing.

In theory, such demand-supply imbalances would not cause prices to deviate from fair value in a material way (or for very long), because active capital would immediately move to buy where there is excess supply and sell where there is excess demand, thereby quickly intermediating away the imbalances.

In reality, there are frictions that prevent active capital from so seamlessly intermediating away these temporary demand-supply imbalances. These include balance sheet restrictions, mark-to-market sensitivity, mandate restrictions, lack of expertise, lack of incentives, differing investment strategies and regulatory considerations.

None of this is new. These underlying drivers of market inefficiency have been around since markets first existed. But what has changed since 2008 is that the opportunity around market inefficiency and accessing RV mispricing as a return source has grown substantially.

This is largely because of structural changes in the banking industry, combined with restrictions on leverage and counterparty credit risk that have constrained the activities of the biggest players in this space (bank trading desks and hedge funds).

Prior to the 2008 financial crisis most of the RV mispricing created by market inefficiency was captured by traders working at banks. With large unconstrained balance sheets and low cost of capital, they were ideally placed to generate profits by intermediating the temporary demand-supply imbalances that caused mispricing.

As such, most of the return potential in RV strategies was captured by banks and there was less available for others to access. Banks were by far the biggest players in this space.

Post 2008, bank balance sheets are highly constrained, proprietary trading has been restricted and the cost of capital for banks has increased. All this means that traders at banks are now much less willing and able to engage in this activity.

This change has had two effects;

  • banks are now less willing and able to intermediate temporary demand-supply balances, resulting in larger divergences of prices from fair value
  • banks are less able to capture these divergences in their own trading books

As a result, there are now more of these opportunities available and far less competition to access them.

The significant decline in fixed income trading revenues of large global banks since 2009, as they scaled back these trading activities, highlights just how profitable this opportunity set used to be for the banks and is now open to others with the right expertise and experience to take advantage of it.

Another group of market participants who take advantage RV mispricing are hedge funds. They continue to do this but have also been indirectly affected by bank balance sheet constraints. This is because most fixed income hedge fund strategies rely heavily on leverage, and that leverage comes from the same bank balance sheets that are now severely restricted and therefore is less available and costlier.

It’s not a coincidence that levered hedge fund assets under management have declined over the past 10 years.

A recent research report by the Federal Reserve Bank of New York covered these concepts in detail, with some key findings being;

“Since the 2007-09 financial crisis, the prices of closely related assets have shown persistent deviations – so-called basis spreads. Because such disparities create apparent profit opportunities, the question arises of why they are not arbitraged away. In a recent Staff Report, we argue that post-crisis changes to regulation and market structure have increased the costs to banks of participating in spread-narrowing trades, creating limits to arbitrage. In addition, although one might expect hedge funds to act as arbitrageurs, we find evidence that post-crisis regulation affects not only the targeted banks but also spills over to less regulated firms that rely on bank intermediation for their arbitrage strategies.”

“The question, then, is why less regulated arbitrageurs such as hedge funds don’t substitute for banks’ lower arbitrage activity. Our hypothesis is that, to the extent that arbitrageurs rely on regulated institutions for funding, clearing, and execution services, even non-regulated arbitrageurs may be affected by post-crisis regulations. Consistent with this hypothesis, we find evidence that … assets under management (AUM) for levered funds have declined significantly more in recent years than for unlevered funds.”

(Full report – Bank Intermediated Arbitrage)

Two additional factors relating to non-economic market participants have also contributed to the growing opportunity;

  • extreme central bank intervention in bond markets motivated by policy objectives
  • rapidly growing passive fixed income funds motivated by index tracking

Both buy and sell bonds regardless of valuations, thereby causing RV mispricing.

All these factors combined have increased opportunities for investors with the right expertise to profit from the pricing inefficiencies left in their wake.

 

1 to be more technically precise, a violation of either of these conditions results in arbitrage opportunities;

  • two securities with the same payoffs in all scenarios should be priced the same (Kenneth Arrow won a Nobel prize in economics for proving this)
  • two securities with the same risks should be priced to offer the same expected returns