Leveraged Fixed Income Arbitrage
Most folks might not even recognize what leveraged fixed income arbitrage is. Most folks will recall the name Long-Term Capital Management, though.
LTCM was the massive hedge fund that unraveled in 1998 after a small misstep for the global financial market led to a massive $4.6 billion collapse in the value of the fund’s holdings.
The reason the fund was able to collapse in the first place? Leveraged fixed income arbitrage, which essentially is the practice of buying bonds low in one place, and simultaneously selling those bonds in another place. The price difference might only be pennies, but if you can trade big enough positions, scraping those pennies off can lead to sizable profits.
So, to maximize the size of its scalping-like profits, Long Term Capital Management used so-called (and completely legal) leverage as a way to buy way more fixed income instruments than it actually had the cash to pay for. No big deal, as the odds of that leverage working against the company and closing the arbitrage gap was 1 in 1,000.
Funny thing, though. The market found itself in that 1-in-1,000 scenario in 1998, and LTCM began to fall apart as a result.
In hindsight, the fund’s investors should have known that those annual returns of 40% had meant the firm was walking a tightrope it couldn’t stay on forever.