What Is Fixed-Income Relative Value Investing (FI-RV)?

Fixed-income relative value investing (FI-RV) is an investment strategy that focuses on identifying and exploiting price discrepancies between related fixed-income securities. Unlike traditional fixed-income investing, which often emphasizes income generation and capital preservation, FI-RV strategies aim to profit from small, relative differences in the valuation of bonds, interest rate swaps or other fixed-income instruments. This approach is generally employed by hedge funds and other sophisticated investors exploring opportunities beyond conventional fixed-income strategies.

Interested in adding fixed-income relative value investing to your portfolio? Consider reaching out to a financial advisor .

What Is Fixed-Income Relative Value Investing?

Fixed-income relative value investing involves analyzing and trading fixed-income securities based on their relative value rather than their absolute price. Traders try to find a security that has temporarily become less or more expensive than another identical or similar security. The goal is to capitalize on pricing inefficiencies or mispricings.

For example, an investor might compare yields of two similar bonds issued by different companies or governments. If one bond appears undervalued relative to the other, the investor might buy the undervalued bond and sell the overvalued one. These strategies can be applied across a wide range of fixed-income securities, including government bonds , corporate bonds , interest rate swaps and mortgage-backed securities .

Examples of Fixed-Income Relative Value Investing Strategies

Several strategies rely on fixed-income relative value investing, each targeting specific types of price discrepancies. Here are six general examples:

• Inflation-linked bonds vs. nominal bonds : This strategy involves comparing the relative value of inflation-linked bonds (which provide protection against inflation) and nominal bonds (which don't protect against inflation). Investors might go long on inflation-linked bonds if they believe inflation will rise, while at the same time shorting  nominal bonds to hedge against the possibility of higher interest rates. The goal is to profit from the relative performance of these two bond types based on inflation expectations.
• Yield curve relative value : In this strategy, investors take positions on different points along the yield curve, which plots interest rates against bond maturities. For example, an investor might go long on short-term bonds and short on long-term bonds if they believe the yield curve will flatten. This strategy seeks to profit from changes in the shape of the yield curve.
• Cash-futures basis : This strategy involves trading the difference between the price of a bond and its corresponding futures contract . If the futures contract is mispriced relative to the bond, an investor might buy the bond and sell the futures contract or vice versa. The goal is to profit from the convergence of the two prices as the futures contract approaches expiration.
• Swap spreads : Swap spreads represent the difference between the yield of a government bond and the fixed rate on an interest rate swap . A swap spread strategy might involve taking positions based on expected changes in swap spreads, which can be influenced by factors such as credit risk, liquidity and demand for government bonds versus swaps.
• Basis swaps : Basis swaps involve institutions exchanging cash flows between two floating-rate instruments, typically in different currencies or based on different benchmarks. Investors might use this strategy to profit from relative changes in interest rates or currency values, betting on the movement of the spread between the two rates.
• Cross currency basis : This strategy takes advantage of differences in the implied interest rates between currencies . Investors might engage in cross currency swaps, exchanging payments in one currency for payments in another, to profit from discrepancies in the cross currency basis, which can arise due to supply and demand imbalances in foreign exchange markets.

Benefits of Fixed-Income Relative Value Investing

FI-RV strategies seek to exploit market inefficiencies, offering the potential for higher returns compared to traditional fixed-income investing. By identifying and trading on relative mispricings, investors can capture profits that might not be available through conventional buy-and-hold strategies.

And because FI-RV strategies often involve taking both long and short positions, they can be used to hedge against broader market risks. For example, if an investor is concerned about interest rate changes, they can structure their trades to minimize exposure to this risk while still pursuing profit opportunities.

These strategies also help diversify an investment portfolio, especially within the fixed-income portion. Diversification reduces overall portfolio risk, especially during periods of market volatility.

Another benefit of FI-RV strategies is that they are designed to be market-neutral, meaning they are not dependent on the overall direction of the market. This can be advantageous in uncertain or declining markets, as the strategy focuses on the relative performance of securities rather than their absolute performance.

FI-RV Risks

Fixed-income relative value investing only works if the investor can accurately identify and quickly act on pricing discrepancies before the market corrects them. FI-RV strategies are often employed by hedge funds, institutional investors and sophisticated individual investors who have advanced analytical tools and the expertise needed to assess complex fixed-income instruments. Ordinary individual investors rarely engage in FI-RV strategies.

One of the most well-known names in FI-RV is long-term capital management, a large hedge fund that employed the strategy to considerable success in the late 1990s. Then a series of international financial crises caused massive losses, a government bailout and eventual liquidation.

The episode highlights risks that go with Fi-RV investing, especially when leverage is used to increase the return on capital, which is common given the small size of the profit opportunities compared to the nominal value of the securities being traded. High leverage makes it necessary for FI-RV investors to accurately assess liquidity and other risks.

Bottom Line

Fixed-income relative value investing is a strategy that can offer opportunities for investors seeking to enhance their returns and manage risk within a fixed-income portfolio. These strategies require significant expertise and access to advanced tools and technologies and are generally reserved for use by hedge funds and institutions. However, for sophisticated investors they may be able to provide a valuable edge in capitalizing on market inefficiencies.

Tips for Investment Planning

• A financial advisor can work with you to build an investment portfolio based on your goals and risk level. SmartAsset's free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now .
• If you want to know how much your portfolio will be worth at a specific date in the future, SmartAsset's investment return and growth calculator can help you get an estimate.

Photo credit: ©iStock.com/Jaime Grajales Benjumea, ©iStock.com/nortonrsx, ©iStock.com/Gerardo Huitrón

The post What Is Fixed-Income Relative Value Investing (FI-RV)? appeared first on SmartReads by SmartAsset .