Matrix Trading: What it is, Risks, Example

What Is Matrix Trading?

Matrix trading is a fixed income trading strategy that looks for discrepancies in the yield curve, which an investor can capitalize upon by instituting a bond swap. Discrepancies come about when current yields on a particular class of bond—such as corporate or municipal, for example—do not match up with the rest of the yield curve or to its historical norms.

Understanding Matrix Trading

Matrix trading is a strategy of swapping bonds in order to take advantage of temporary differences in the yield spread between bonds with different ratings or different classes. An investor performing a matrix trade could be looking to profit purely as an arbitrageur—by waiting for the market to "correct" a yield spread discrepancy—or by trading up for free yield, for example, by swapping debt with similar risks but different risk premiums.

Matrix trading may require matrix pricing. When a particular fixed income instrument isn't heavily traded, the trader must come up with a value for it because recent prices may not always reflect the real value in a thinly traded market. Matrix pricing involves estimating what the price of a bond should be by looking at similar debt issues and then applying algorithms and formulas to tease out a reasonable value. If the current price is different than the expected value, then the trader can devise a strategy for taking advantage of the mispricing.

Matrix traders ultimately expect that apparent mispricings in relative yields are anomalous and will correct over a short period of time. Yield curves and yield spreads can be thrown off historical patterns for any number of reasons, but most of those reasons will have a common source: uncertainty on the part of traders.

Individual classes of bonds may also be inefficiently priced for a period of time, like when a high-profile corporate default sends shock waves through other corporate debt instruments with similar ratings. While certain bonds may not be directly affected by the event at all, they still experience mispricing as traders look to reshuffle positions or view the future as uncertain. As the dust settles, the prices tend to return to their proper values.

Matrix Trading Risks

Matrix trading is not without risk. Mispricings can occur for good reason, and may not correct back to expected levels. A higher yield than expected could be due to selling pressure in a bond related to the underlying company's struggles that haven't been fully realized yet.

Also, conditions may continue to deteriorate, even if there is no good reason for it. During a market panic, mispricings can be extensive and long-lasting. While the mispricing may resolve itself, a trader may not be able to withstand the losses in the meantime.

Like any strategy, matrix traders profit when what they expect to happen occurs. If they are wrong, and the mispricing doesn't correct itself or continues to move against them resulting in a loss, they will look to exit the position and limit losses.

Example of Matrix Trading

Assume that the difference in interest rates between U.S. short-term Treasuries and AAA-rated corporate bonds has historically been 2%, while the difference between Treasuries and AA-rated bonds is usually 2.5%.

Company XYZ has an AAA-rated bond yielding 4% and its competitor ABC Corp. has an AA-rated bond yielding 4.2%. The difference between the AAA and AA bond is just 0.2% instead of the historic 0.5%. A matrix trader would buy the AAA-rated bond and sell the AA-rated bond, expecting the yield spread to widen (causing the price of the AA bond to fall as its yield rises).

Traders may also look at ranges instead of specific numbers, and become interested when the spread goes outside the historical range. For example, a trader may notice that the spread between AA and AAA is often contained between 0.4% and 0.7%. If a bond moves significantly outside this range, it alerts the trader that something important is going on, or that there is potential mispricing that can be taken advantage of.

Similar strategies can be employed for bonds situated in different maturities, in different economic sectors, and in different countries or locales.