AAA Spread Above MGS: 3s vs 5s
Arbitrage Opportunity
There seems to be a mispricing between the 3-year AAA spread above
MGS versus that of the 5-year AAA spread above MGS. Our conclusion is
that there is an arbitrage opportunity to take advantage of the difference in
spread between these two groups of securities.
The BNM indicative yields show that 5-year AAA spread above MGS had
narrowed drastically since early 2009, while 3-year AAA spread above
MGS only narrowed slightly. The reasons for the above are due to (i) a high
5-year MGS yield caused by the large supply of short-term govvies as
scheduled in the auction calendar, and (ii) the relatively low 3-year MGS yield
due to market’s believe that the OPR is likely to remain unchanged for the next
1-1.5 years.
Intuitively, we would expect the 3-year AAA spread above MGS to be
almost the same as the 5-year AAA spread above MGS. Some may even
argue that the 5-year AAA spread above MGS should be higher than the 3-
year given the extra risk of holding a longer tenure AAA paper.
However, in reality we see the exact opposite. The graph overleaf shows
the actual traded data (in the last 1 week) of MGS bonds and certain AAA
papers. (Note: This is not indicative levels but actual traded levels for both
MGS and AAA securities). We have selected Rantau and Cagamas in this
example as they were quite actively traded in the last 2 weeks. Our focus will
be on the short-end of the curve, namely 5-years and below in tenure.
We note a number of potential arbitrage opportunities. Here we assume
the credit risk of the selected AAA securities is negligible, and also that liquidity
is healthy such that there will be no problems squaring the position at the
appropriate time.
One example of an arbitrage opportunity is as follows. You may want to
position it to be duration neutral in order to hedge against any parallel shifts of
the curves.
- Buy Rantau’11 at 3.21%
- Short MJ4/11 at 2.49%
- Buy MJ7/13 at 3.60%
- Short Rantau’13 at 3.98%
We recommend that the trades be unwind when the spread between
Rantau’11 and MJ4/11 have narrowed and/or when the spread between
MJ7/13 and Rantau’13 have widen sufficiently.
This strategy will likely provide the largest return if market start to believe
that OPR will be hiked, thereby pushing the 3-year MGS yield higher and at the
same time narrowing the 3-year AAA spread above MGS.
Alternatively, should there be difficulties shorting securities, we
recommend buying the Rantau’11 outright as it provides a lucrative 72 bps
above the MJ4/11 with minimal differences in credit or liquidity risks.
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