Abstract
We analyse whether portfolios of high-carry developed market government bonds provide better risk-adjusted returns compared to low-carry portfolios and a measure of broad market returns. Carry-based portfolio strategies are assessed in three settings: (1) cross-market for specific maturities, (2) cross-curve for specific markets, and (3) cross-market and cross-curve. Our results show that carry can provide a meaningful predictive signal, but with a varying degree of power and with dependence on the selected sample period. Generally, we observe evidence for time-varying compensation for risks related to carry strategies, and more specifically, that carry strategies appear to underperform in periods of broadly rising interest rates. Overall, our verdict on carry is a little more nuanced than results found in recent studies.
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Notes
- 1.
The carry trade in foreign exchange markets relates to borrowing a low-yielding currency and investing in a high-yielding currency. According to uncovered interest parity (UIP) gains from the interest rate differential (the carry) should be offset by a depreciation in the investment (high yielding) currency. However empirically, the reverse seems to hold true and the investment currency tends to appreciate a little (Brunnermeier et al. 2008).
- 2.
This may be consistent with the broader analysis of factor-based investing relative to active investment management as provided by Ang et al. (2009).
- 3.
The segmented markets thesis states that changing availability of capital that can be deployed for arbitrage trades (i.e. hedge fund capital) can impact the profitability of related trading strategies. This may arise, for instance, because investors are active in different markets and have limited risk bearing abilities (Shleifer and Vishny 1997).
- 4.
Merton (2014) provides an overview of what constitutes a quality factor. A strategy is continuous if the relative strength of the strategy signal translates to the relative size of returns, so that, for instance, the more positive the signal, the more positive the return. The strategy is time-persistent if the strategy works through time, and thus in potentially different market conditions. The strategy is pervasive if the signal works in different markets, for instance, across geopolitical borders (or indeed across different asset classes). Consistency refers to whether and to what extent a strategy is supported by theory. If not underpinned by some rationale, the strategy could merely be a statistical artefact and more a result of data mining.
- 5.
As the properties of the carry portfolios are assessed on the basis of their returns in excess of the respective short rates, the cross-market strategies imply the assumption that any exchange rate risk is fully hedged whereby the costs of the hedge correspond to the short-rate differentials between the markets (i.e. the covered interest rate parity holds).
- 6.
The Nelson–Siegel formula is given by \( {y}_t^{\tau }={\beta}_t^1+{\beta}_t^2\cdot \left(\frac{1-{e}^{-\lambda \cdot \tau }}{\lambda \cdot \tau}\right)+{\beta}_t^3\cdot \left(\frac{1-{e}^{-\lambda \cdot \tau }}{\lambda \cdot \tau }-{e}^{-\lambda \cdot \tau}\right) \) where the observed spot rate y for maturity τ years at t is explained by three parameters, the level (\( {\beta}_t^1 \)), slope (\( {\beta}_t^2 \)), and curvature (\( {\beta}_t^3 \)) as well as λ. λ is fixed at 0.7173 calculated in terms of years (0.0609 calculated in months) across countries and across time following a standard estimation technique (Diebold and Li 2006). All quantitative work in this study, including calculation of zero coupon yields using the Nelson–Siegel approach and calculation of returns to carry-focused portfolios, is undertaken using the BIS Asset Management Asset Allocation Module (BAAM), a Matlab-based module developed jointly by the BIS Asset Management and Banco Central do Brasil.
- 7.
Koijen et al. (2018) show how this equation is consistent even when calculating carry for assets denominated in different currencies, where the assumption, consistent with unchanging market conditions, is that the exchange rate stays the same from one period to the next.
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Coche, J., Knezevic, M., Sahakyan, V. (2018). Carry On?. In: Bulusu, N., Coche, J., Reveiz, A., Rivadeneyra, F., Sahakyan, V., Yanou, G. (eds) Advances in the Practice of Public Investment Management. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-90245-6_6
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DOI: https://doi.org/10.1007/978-3-319-90245-6_6
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