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 (e.g. corporate, municipal, etc.) do not match up with the rest of the yield curve or to its historical norms. Matrix pricing involves interpolating the current price of a bond by looking at similar debt issues and then applying algorithms and formulas to tease out a reasonable value, or by identifying discrepancies in bond prices in the same manner in order to take advantage of these differences from expectations.

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 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. For instance, the difference in interest rate between U.S. short term Treasuries and AAA rated corporate bonds has historically been, say, 2% while that between Treasuries and AA rated bonds is 2.5%. Now say that 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). Similar strategies can be employed for bonds situated in different maturities, in different economic sectors, and in different countries or locales.

Matrix traders ultimately expect that apparent mispricings in relative yields are anomolous 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 about the future of financial markets. Individual classes of bonds may also be inefficiently priced for a period of time, such as a high-profile corporate default that sends shock waves through corporate debt with similar ratings.