Despite the coronavirus outbreak in China that has partially shut down the 2nd largest economy and downgraded global growth expectations, investor appetite for U.S. ‘long duration’ assets seems unabated as both U.S. growth (technology) stocks and long maturity U.S. Treasuries have reached new highs.
With the U.S. Federal Reserve committed to keeping rates low (or perhaps cutting them in the face of the coronavirus growth scare) and supporting the collateralized overnight lending market (repo) through at least April of this year, we’ve seen a compression in risk-based trading strategies, or so-called carry trades.
Last November, we published an article on ETF.com with the provocative title, “The Year Smart Beta Died?” In the article, we noted how most of the major risk-based factors had been underperforming in 2019 and wondered whether the struggle of ‘smart beta’ versus plain-vanilla market cap weighting would signal the death knell for smart beta. Perhaps, 2020 will also see a similar shake-out with the global carry trade and will test the ‘strong hands’ (and those with deep pockets financing) just as 2019 tested smart beta investors.
The Carry Trade
In its basic form, a carry trade consists of borrowing (or going short) a low yielding asset and investing (or going long) an asset that provides a higher rate of return. It’s most commonly employed in currency trading – a popular carry trade in the mid-2000s was to borrow (go short) the Japanese yen due to its rock bottom interest rates and invest (go long) in higher yielding currencies. It is also employed across time-based fixed income curves (i.e. the U.S. Treasury yield curve) and futures contracts (commodities and volatility) where the goal is to capture the ‘roll yield’ to take advantage of steepness in the curve as longer dated positions roll down to shorter-dated positions producing a ‘yield’ from the roll down.
The carry trade concept can be extended to any strategy that involves capturing a spread (usually with leverage) between a higher yielding asset financed with borrowing in a lower yielding asset. Basically, the strategy hopes to not only capture the ‘vig’ embedded in the spread but also from compression in the spread (the capital gain cherry on top of the sundae). Carry trade is typically distinguished from other popular trading strategies such as event-driven (i.e. merger arbitrage, corporate actions, index arbitrage) and trend-following, typically the backbone of many commodity trading advisor (CTA) funds.
The carry trader is anticipating that realized volatility of the underlying assets will remain lower than the ‘implied’ volatility embedded in the pricing of those assets. It amounts to a form of ‘insurance’ to financial participants unwilling to expose themselves to significant ‘tail losses.’ Carry trades employing large amounts of leverage to goose the carry trade returns are also ‘short gamma’ where their risk exposure accelerates should underlying volatility increase (Long-Term Capital blowing up in 1998 is an extreme example).
In environments where carry trade spreads are wide (typically following an extended period of volatility), the strategy can look quite attractive as long as the risk regime stabilizes or doesn’t get worse. Using implied versus realized volatility on the S&P 500 as a proxy, carry trades typically work 80% of the time, but it’s the remaining 20%, regimes in which realized volatility spikes and spreads widen, that can wipe out profits generated from the 80% (and produce losses depending on how much leverage is employed).
Carry Trade Example – Short Volatility (via VIX Futures Roll-Down)
For instance, 2017 was a popular year for investors to be short volatility as the S&P VIX curve was exceptionally steep. Those short longer-dated VIX futures earned 10%+ unlevered returns just from the roll-down with spot VIX levels dropping to 9% implied volatility. However, many who were short volatility in early 2018 got wiped out when VIX jumped from 9% to 30-40% over the span of several weeks, but the steep curve prior to the VIX spike made the short vol trade especially attractive.
Today, ‘spot’ volatility is elevated but collared with a sanguine U.S. market outlook and a Federal Reserve injecting liquidity via its ‘temporary’ support of the repo market. However, those desiring to short volatility in today’s risk environment are being compensated with about half the ‘roll yield’ from the 2016-2017 period. This can be seen in the VIX futures contango curve produced by vixcentral.com (Figures 1 and 2). One can argue that today’s short vol trade is operating in a more stable environment than the one experienced in 2016-2017 that brought in a lot of short vol ‘tourists’ wanting to take advantage of the steep curve, but it also means that short vol traders are picking up pennies, instead of nickels, in front of a steamroller.
Figure 1 – VIX Futures Contango About Half as Steep versus 2016-2017
Figure 2 – VIX Futures Curve Much Flatter Today Versus 3Q2017
Little Spread to Be Had Across U.S. Fixed Income
Outside of interest rate risk (duration), fixed income investors can be compensated for taking on additional risk in two primary ways: 1) term structure (or steepness of the yield curve) and 2) credit spreads (default risk above sovereign debt). Figure 3 displays the current term structure for U.S. Treasuries, A-Rated corporate bonds, and AAA-rated municipal bonds. Observe how flat or inverted the short end of the curves are out to 5 years before the curves start to steepen. The bond market is anticipating lower Fed Funds rates this year and beyond. To get any positive ‘roll-down’ yield, investors must venture further out at least to 7 years.
Figure 3 – Not Much Roll-Down to Be Had: Flat/Inverted Term Structures Out to Intermediate Maturities
Source: Bloomberg as of 2/11/2020.
One can interpret the flatness or inversion as fixed income investors pricing the inevitable which is for the Fed to cut rates at least once by the end of the year (and perhaps as soon as before the election). With the Fed increasingly worried about the prospects of falling inflation, the Fed will likely follow the bond market’s cue and follow through on rate cuts, barring an inflationary surprise.
Corporate credit remains resilient in the face of a global growth scare stemming from coronavirus (Figure 4). BBB-rated spreads saw a minimal spike before narrowing back to cycle lows; high yield spreads have widened but this was primarily due to highly-levered energy borrowers feeling the sting of the plunge in oil prices as investors anticipate a drop in energy demand due to the coronavirus. Not much carry can be earned by investing in corporate credit outside of the energy sector.
Figure 4 – Corporate Credit Remains Resilient in the Face of a Global Growth Scare
Conversation with an Institutional Carry Trader
3D had an opportunity to hear from a large institutional strategist that incorporates global carry trades as part of a multi-trading strategy. The strategist chose not to be named, so we paraphrase some excerpts from our conversation.
The strategist holds a less-than-neutral view on the opportunities presented in the carry trade noting that fixed income spreads are generally negative while currency (fx) and commodity spreads are neutral.
2019 had been a strong year for global carry due primarily to a convergence in global sovereign bond yields, in particular the Australian bond market. A large part of this was (and is) due to accommodative central bank policies and how such accommodation has been transmitted through investment risk-taking. Central banks have not permanently suppressed price dispersion, but their accommodative policies have helped contribute to it.
The market is still susceptible to sharp risk reversals such as what was observed in 4Q2018; however, these reversals have become few and far between. This is not to suggest price dispersion is not taking place; for instance, there is widening dispersion between corporate haves and have-nots, whether in equity or corporate credit pricing. Less-than-healthy corporate borrowers are paying a higher penalty versus their healthier counterparts. This dispersion can also be observed in a ‘high quality’ factor where the dispersion in profitability (or return on equity) between high versus low quality companies is quite wide even if the valuation dispersions are not.
Overall, the strategist would allocate less capital to global carry than to other strategies. Spreads in general are now below long-term averages, especially across sovereign-issued bonds. There are fewer opportunities to capture carry going forward.
The larger debate, one in which the strategist was reluctant to speculate on, is whether global central bank policies can continue to suppress volatility in the event it ever erupts again as it did in 4Q2018 (the last major period of equity and corporate credit volatility) or during the brief bout of volatility last August/September 2019 when repo rates skyrocketed to 9%. In particular, is the Fed trapped into providing longer-than-temporary support to repo market operations? What would happen in the event they do try to exit? Would extended market volatility force them to reverse their exit just like the market forced the Fed to reverse its 2018 policy rate hikes and pursuit of monetary policy normalization?
Keep Calm and Carry On?
The knock-on effects to global growth from the coronavirus pandemic have not fully manifested themselves yet, but U.S. asset pricing seems to be taking the pandemic in stride as U.S. equity benchmarks reach new highs and corporate credit spreads remain narrow (outside of energy borrowers). How much of this can be attributed to an accommodative Fed, how much of it due to the resilient U.S. economy, and/or how much of it can be attributed to high corporate profitability (helped in part by share repurchases) remains to be seen. But investors seeking ‘carry’ will find opportunities wanting in the current risk regime.
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