Introduction to Pairs Trading

Pairs trading is a sophisticated investment strategy that involves identifying two or more co-moving assets and exploiting their price discrepancies by taking long and short positions. This approach is particularly effective in markets where inefficiencies are more pronounced, such as emerging markets or sectors with high volatility like closed-end funds (CEFs)[1]. In this article, we will delve into a pairs trading strategy involving two CEFs: Eagle Point Credit Company (ECC) and OFS Credit Company Inc. (OCCI).

Understanding ECC and OCCI

ECC Overview

Eagle Point Credit Company is a closed-end investment management company that focuses on generating current income and capital appreciation by investing in a variety of credit instruments. ECC is known for its diversified portfolio, which includes CLO debt and equity, leveraged loans, and high-yield bonds. ECC's performance has been relatively stable, with a total NAV return around 10% for the year, making it a popular choice among income investors[4].

OCCI Overview

OFS Credit Company Inc., on the other hand, also invests primarily in credit instruments, including CLO debt and equity, traditional corporate credit, and opportunistic credit investments. OCCI has faced challenges due to higher leverage and worse credit metrics compared to ECC, but its preferred stock offers attractive yields, making it appealing for yield-hunting investors[3][5].

Pairs Trading Strategy

Why Pairs Trading?

Pairs trading offers several advantages, including market neutrality and the potential for consistent returns regardless of overall market conditions. By identifying co-moving assets like ECC and OCCI, investors can capitalize on temporary mispricings without needing to predict broader market trends[1].

Identifying Co-Moving Assets

To apply pairs trading effectively, it's crucial to identify assets that historically move together. ECC and OCCI, both being CLO-focused CEFs, share similarities in their investment strategies, making them potential candidates for a pairs trade. However, their differing performance metrics and risk profiles must be carefully considered.

Trading Rules

1. Distance Approach: This method involves using correlation metrics to identify co-moving assets. Once identified, simple threshold rules can trigger trading signals when the spread between the two assets deviates significantly from its mean[1].

2. Time Series Approach: This involves modeling the spread between ECC and OCCI as a mean-reverting process. Popular models include the Ornstein-Uhlenbeck process, which helps determine optimal entry and exit points based on historical data[1].

3. Stochastic Control Approach: This advanced strategy uses stochastic processes to optimize trading rules without forecasting future spread movements[1].

Challenges and Opportunities

Challenges

• High Management Fees: Both ECC and OCCI face challenges due to high management fees, which can erode investor returns over time[2].
• Leverage and Credit Metrics: OCCI's higher leverage and worse credit metrics compared to ECC introduce additional risk, making it crucial to monitor and adjust positions accordingly[3].

Opportunities

• Yield Hunting: OCCI's preferred stock offers an attractive yield, making it a viable option for investors seeking income[3].
• Market Inefficiencies: The CEF market often experiences inefficiencies, providing opportunities for pairs traders to capitalize on mispricings[1].

Conclusion

Pairs trading between ECC and OCCI presents both challenges and opportunities. While ECC offers stability and a diversified portfolio, OCCI provides attractive yields despite higher risk. By leveraging pairs trading strategies, investors can potentially exploit market inefficiencies and achieve market-neutral returns. However, careful analysis of each fund's performance, risk profile, and market conditions is essential for success.

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