How does the carry trade work in fixed income?

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AcadiFi · Accepted Answer

The fixed income carry trade buys higher-yielding bonds and funds them with lower-yielding liabilities or short positions, earning the yield differential assuming conditions remain stable. In pure form: long 10-year emerging-market local debt yielding 9%, short 10-year US Treasury yielding 4%, net carry 5% before duration hedging and FX hedging.

Implementation forms:

1. Cross-currency carry: long high-yielding sovereign (Brazil, Mexico, South Africa), short low-yielding sovereign (Germany, Japan). Hedge duration to neutralize rate direction; carry = yield differential minus FX hedge cost.

2. Cross-credit carry: long BB corporate, short A corporate within same sector. Earn spread differential; risk is credit deterioration of high-yield leg.

3. Intra-curve roll-down carry: hold 5-year bond funded short-term; as time passes, position rolls down the curve and benefits from shorter-maturity lower yield. Carry = term premium plus roll-down.

For Stockwell Global Carry with $4 billion: basket of 10-15 high-carry positions, risk-weighted equal contributions, monthly rebalancing based on carry rankings. Historical performance: 5-8% annualized returns with 10-15% volatility; Sharpe 0.4-0.6 in backtests over 20 years.

Risks: carry trades suffer sharp reversals during risk-off episodes. August 1998 LTCM crisis, 2008 GFC, and March 2020 COVID shock all saw 15-25% drawdowns in carry strategies as high-yielders sold off and safe-havens rallied. Skewness is negative; kurtosis high.

Risk management: position sizing based on volatility; stress testing against historical crises; tail hedging with out-of-money options; dynamic de-risking when volatility indicators (MOVE, VIX) exceed thresholds. 'Carry works until it doesn't' is the cautionary maxim.

How does the carry trade work in fixed income?

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