Having been stuck in a yearlong rut, fixed-income arbitrage hedge funds are finally posting consistent returns. The Hedgefund.net index of 124 funds – which represents more than $50 billion in bond arbitrage assets – posted a gain of 0.54% for October, and is up 5.43% so far this year. It was the third consecutive monthly increase for the index, although it looks like the index will close below last year’s 9.25% average return.

Fixed-income arbitrage funds buy bonds – most often some combination of American Treasury and agency bonds, and mortgage- and asset-backed securities and their derivatives – that have fallen out of a traditional pricing pattern.

For example, if mortgage pass-through bonds usually trade 50 basis points wider than Treasuries but have recently started trading at 57 basis points wider, the hedge-fund manager will buy the pass-through bond and sell the Treasury bond short, on the belief that the bonds will settle into the normal relationship.

Because so many hedge funds use leverage, the seeming profit margin in this fictional trade – seven cents – gets expanded to 28 or 30 cents given the use of leverage. Moreover, given that interest rates are still at near-historic levels, the “carry trade” remains a popular and lucrative strategy for many bond-arbitrage funds. This is when fund managers buy higher-yielding longer-maturity assets and finance those purchases with low interest rate short-term leverage from a bank or dealer. This strategy is still profitable, but as rates begin to rise, the higher financing costs will force many managers to exit the trade.

For October and into the first week of this month, the bond market’s traders and hedge-fund managers were preoccupied with the rising cost of oil and what was then seen as the dead heat of the presidential campaign. Seeking a safe haven for their assets, many managers bought Treasuries and agency bonds, sending the benchmark 10-year on rally to 4.03% by early November, a gain of nine basis points on the month.

For fixed-income arbitrage managers who trade primarily mortgage bonds, perhaps 50% of the sector, the lack of supply of new bonds has made existing bonds more expensive given the broad-based demand for mortgage paper. Issuance has slowed substantially – almost 20% from this time last year – because the number of residential mortgages being issued by banks and finance companies has slowed. Mortgage finance officials speculate that this is because rates have been at historic lows for over two years and that the majority of consumers with decent credit have already refinanced their mortgages several times.