Phil Milburn

Thinking inside the box

Phil Milburn

Some fixed income alpha-generating strategies are great in theory but rarely ever implemented in practice. It therefore gives me pleasure to be able to say we have put on a “box trade”, which is a very rare chance to invest in this type of low-risk alpha opportunity.

What is a box trade?

A box trade has four parts to it, hence the name. It is normally used to take advantage of price dislocations in a very low-risk way. You position such that you are long risk the diagonally opposite corners (A and D) and short risk the other two (B and C), meaning market risk along the vectors (AB) is neutralised.

Box trade 

A classic example from the land of equities would be if, for example, Vodafone’s ADRs (American Depository Receipts) looked cheap compared to its main UK listing and the opposite applied for BT. You would buy Vodafone’s ADRs and short the UK listing and the opposite applies for BT.

Box trade example 

The above position is long and short of each of the four risks involved, thus you are just taking advantage of price dislocation. This does not mean that the prices cannot move further against you but it is isolating the alpha from the beta.

In most markets, these kinds of trades are rare. Within fixed income, you need to be able to create the shorts: the Liontrust Global Fixed Income team only uses liquid instruments, such as government bond futures or credit default swap indices, so we are constrained to rates or asset allocation positions for box trades. There is not enough liquidity in single name credit default swaps so the bid/offer ends up destroying the idea; a similar problem arises with interest rate swaps where the exit is more costly than the entrance.

A France versus Germany 10s30s curve box trade

We have identified a pricing anomaly, however, which is that the French government bond curve is too steep relative to that in Germany: specifically, we are referring to the 10-and 30-year tenors.

 spread of france vs germany

Source: Bloomberg, Liontrust as at 19.07.19

A different and mathematically equivalent way of looking at this is that the spread between 10-year French and German bonds is too narrow and the one between their respective 30-year debt issues is too wide.

The spreads between the two countries’ 10-year debt (blue) and 30-year debt (orange) are shown on the left hand axis in basis points in the graph above. The grey shaded area shows the differential between the two - note the narrower scale on the right-hand axis which shows the lower risk nature of this position.

10s30s yield curves france and germany 

Source: Bloomberg, Liontrust as at 19.07.19

This is one of those rare occasions when there is both a price dislocation and four liquid instruments with which we can capture it in such a way that the bid/offer doesn’t destroy the upside. The picture below shows what we have done in half a year’s worth of duration contribution for each leg:

Box trade germany vs france risk

We have entered into the shaded area in the earlier graph at 39 basis points and if levels go back to where they were a year ago (a 20bps differential), we will make almost 10 basis points of profit. This is not going to make you rich but is an example of a low-risk alpha opportunity in these crazy markets. Box trades are very rare, in fact rare enough that I felt compelled to write about this one.

For a comprehensive list of common financial words and terms, see our glossary here.


Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The majority of the Liontrust Sustainable Future Funds have holdings which are denominated in currencies other than Sterling and may be affected by movements in exchange rates. Some of these funds invest in emerging markets which may involve a higher element of risk due to less well regulated markets and political and economic instability. Consequently the value of an investment may rise or fall in line with the exchange rates. Liontrust UK Ethical Fund, Liontrust SF European Growth Fund and Liontrust SF UK Growth Fund invest geographically in a narrow range and has a concentrated portfolio of securities, there is an increased risk of volatility which may result in frequent rises and falls in the Fund’s share price. Liontrust SF Managed Fund, Liontrust SF Corporate Bond Fund, Liontrust SF Cautious Managed Fund, Liontrust SF Defensive Managed Fund and Liontrust Monthly Income Bond Fund invest in bonds and other fixed-interest securities - fluctuations in interest rates are likely to affect the value of these financial instruments. If long-term interest rates rise, the value of your shares is likely to fall. If you need to access your money quickly it is possible that, in difficult market conditions, it could be hard to sell holdings in corporate bond funds. This is because there is low trading activity in the markets for many of the bonds held by these funds. Mentioned above five funds can also invest in derivatives. Derivatives are used to protect against currencies, credit and interests rates move or for investment purposes. There is a risk that losses could be made on derivative positions or that the counterparties could fail to complete on transactions.


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Thursday, July 25, 2019, 10:30 AM