Fixed Income Arbitrage in a Financial Crisis (A): US Treasuries in November 2008 Custom Case Solution & Analysis

Evidence Brief: Fixed Income Arbitrage in a Financial Crisis

Financial Metrics

On-the-Run vs Off-the-Run Spread: The spread between the most recently issued 10 year Treasury note and the previous issue reached approximately 40 to 70 basis points in November 2008. Historically, this spread remained below 10 basis points.
Repo Haircuts: Borrowing costs for Treasury collateral increased significantly. Standard haircuts for US Treasuries rose from 0.25 percent to between 3 percent and 5 percent during the peak of the crisis.
Libor-OIS Spread: This measure of credit risk in the interbank market peaked at over 350 basis points in October 2008, signaling extreme systemic stress.
Gearing Ratios: Typical fixed income arbitrage funds operated at gearing levels of 20 to 30 times capital. By late 2008, many were forced to reduce this to below 10 times.
Yield Levels: 10 year Treasury yields dropped toward 3 percent as investors sought safety, yet the pricing of older bonds lagged significantly behind the liquid benchmarks.

Operational Facts

Repo Market Mechanics: The trade relies on the ability to borrow cash against the purchased Off-the-Run bond and borrow the On-the-Run bond to sell it short. This requires a functional repurchase agreement market.
Mark-to-Market Frequency: Prime brokers required daily valuation of positions. Any widening of the spread triggered immediate margin calls, requiring cash or additional collateral.
Counterparty Risk: Following the collapse of Lehman Brothers, the reliability of prime brokers became a primary concern. The risk of collateral being frozen in bankruptcy proceedings increased.
Liquidity Gradient: On-the-Run bonds remained liquid and easily traded. Off-the-Run bonds became increasingly illiquid, with bid-ask spreads widening by a factor of five or more.

Stakeholder Positions

Arbitrage Fund Managers: Viewed the spread as a historic opportunity with guaranteed convergence at maturity but faced immediate liquidation pressure from lenders.
Prime Brokers: Focused on capital preservation and risk reduction. They increased haircuts and reduced the total amount of credit extended to hedge fund clients.
Institutional Investors: Many faced their own liquidity needs and were redeeming capital from hedge funds, forcing managers to sell positions at distressed prices.
US Treasury: Continued regular issuance cycles, which contributed to the supply of new On-the-Run securities while older issues migrated to Off-the-Run status.

Information Gaps

Specific Fund Solvency: The case does not provide the exact cash reserves or unencumbered assets available to the specific fund in question to meet potential margin calls.
Term Funding Availability: It is unclear if the fund had access to term repo (longer than 24 hours) or if they were entirely reliant on overnight rolling credit.
Counterparty Concentration: The degree of exposure to a single prime broker versus a diversified group of lenders is not specified.

Strategic Analysis: The Convergence Dilemma

Core Strategic Question

The fundamental dilemma is whether to deploy scarce capital into a historically wide Treasury arbitrage trade when the risk of technical insolvency due to funding illiquidity outweighs the certainty of eventual profit.

Can the fund survive the path to convergence?
Does the current market dislocation represent a fundamental shift in liquidity pricing or a temporary imbalance?

Structural Analysis

The application of the Limits to Arbitrage framework reveals that while the price discrepancy is high, the costs of holding the position have become prohibitive. Arbitrage is not risk-free when the ability to finance the position is contingent on daily market sentiment. The 10 year Off-the-Run bond is fundamentally the same credit as the On-the-Run bond, but the market is pricing a massive liquidity premium. In a systemic crisis, liquidity becomes more valuable than solvency.

Strategic Options

Option 1: Aggressive Position Expansion

Rationale: Capture once-in-a-generation spreads that must close as the bonds approach maturity.
Trade-offs: High probability of total capital loss if spreads widen further or haircuts increase again.
Resource Requirements: Significant cash reserves to withstand margin calls and stable, long-term credit lines.

Option 2: Selective Entry with Reduced Gearing

Rationale: Participate in the trade but limit the size to a level where the fund can survive a doubling of current haircuts.
Trade-offs: Lower total returns and potential underperformance if the market recovers quickly.
Resource Requirements: Disciplined capital allocation and a shift from overnight to term repo funding.

Option 3: Capital Preservation and Exit

Rationale: Acknowledge that the market environment is too volatile for arbitrage and exit to protect remaining investor capital.
Trade-offs: Realizing current losses and missing the eventual convergence profit.
Resource Requirements: Orderly liquidation of illiquid Off-the-Run positions without triggering a fire sale.

Preliminary Recommendation

The fund should pursue Option 2. The spread is too significant to ignore, but the gearing levels of the previous era are no longer viable. By entering the trade with gearing limited to 5 or 6 times capital and securing term funding, the fund can capture the convergence while maintaining a buffer against further market volatility.

Implementation Roadmap: Risk-Adjusted Execution

Critical Path

Step 1: Funding Audit (Days 1 to 5): Quantify the exact amount of cash available to support margin calls. Negotiate with prime brokers to move from overnight repo to 30 day or 90 day term repo, even at higher interest costs.
Step 2: Position Sizing (Days 6 to 10): Calculate the maximum loss the fund can sustain if the spread widens by another 50 basis points. Set the trade size based on this worst-case scenario.
Step 3: Execution (Days 11 to 20): Build the position in increments. Buy the Off-the-Run bonds and short the On-the-Run bonds in small blocks to avoid moving the market.
Step 4: Monitoring (Daily): Implement a rigorous daily stress test of the portfolio against haircut increases and spread widening.

Key Constraints

Haircut Volatility: The primary constraint is not the bond price but the lender behavior. If haircuts move to 10 percent, the trade fails regardless of the bond yields.
Counterparty Solvency: The fund is only as safe as its prime broker. Diversifying collateral across at least three institutions is mandatory.
Redemption Gates: Investor exits could force a liquidation. The fund must communicate the long-term nature of this trade to investors and potentially invoke redemption gates to protect the strategy.

Risk-Adjusted Implementation Strategy

The strategy must assume that liquidity will worsen before it improves. The fund will only execute the trade if it can secure term funding that covers at least 60 percent of the expected duration of the convergence. If term repo is unavailable, the trade size must be reduced by half. This contingency ensures that the fund is not forced to sell at the point of maximum pain.

Executive Review and BLUF

BLUF

The fixed income arbitrage trade in November 2008 presents a classic trap: a mathematically certain profit obscured by an operationally certain liquidity crisis. The 40 to 70 basis point spread between On-the-Run and Off-the-Run Treasuries is an anomaly that will eventually correct. However, the strategy of the fund must shift from maximizing returns to ensuring survival. High gearing is no longer a viable tool; it is a systemic vulnerability. The fund should enter the trade with a maximum gearing of 5 times capital and only with term-secured financing. Anything else is a gamble on market stability that does not exist. The objective is to be the last firm standing when the market returns to rationality.

Dangerous Assumption

The most dangerous assumption is that Treasury bonds will remain acceptable collateral at predictable haircut levels. In a systemic collapse, even the most secure assets can be subject to arbitrary lending terms or a total withdrawal of credit by panicked prime brokers.

Unaddressed Risks

Counterparty Contagion: The analysis assumes the fund can choose its lenders, but the failure of another major investment bank could freeze the entire repo market, making it impossible to roll over even the most conservative positions.
Regulatory Intervention: Sudden changes in capital requirements for banks could force them to abruptly terminate all hedge fund lending, regardless of the quality of the collateral.

Unconsidered Alternative

The team failed to consider a synthetic approach using interest rate swaps or futures to express the view on the yield curve without the heavy reliance on the physical repo market. While the basis risk is different, the funding requirements are often less sensitive to the specific liquidity of an individual bond issue.