‘Pair trades’ work by going long one bond and short another. In our absolute return bond funds we use pair trades extensively in rates markets to add performance. There’s plenty of fish in the bond market sea; the breadth and depth of global rates markets allows us to find the perfect match.
The beauty of pair trades is that we can make money without taking exposure to the direction of interest rates – a source of performance that is particularly desirable as yields move higher. We do this by sizing the long and short side of each pair in equal duration, as well as finding well-matched assets.
For example, last month we paired together Australia and the US. Australian bonds in our view offered relative value versus the US as the Australian market had prematurely priced in a rate hike in late 2018. We went ‘long’ Australia versus a ‘short’ in the US so that we were exposed to the outperformance of Australian bonds, without being exposed to a generic move higher in yields.
But not all pairs would work out like this, so we have to manage our matchmaking carefully. If we had positioned long Italy versus the US for example (with Italy a ‘riskier’ market than ‘safe-haven’ US Treasuries), the pair would be likely to perform badly in a generic ‘risk-off’ environment and perform well in a ‘risk-on’ market – not a risk-neutral position, or a well-matched pair!
So we would caution, on Valentine’s Day, that blind dates may not be the path to domestic bliss! We would never walk blindly into a pair-trade relationship, rather make sure to understand the correlation between markets and how they change over time. We would also argue that there’s no harm in a bit of caution (expressed as our strict review discipline): always have an exit strategy in mind and remember, not everyone mates for life.